The Ongoing Financial Crisis

I am becoming more and more convinced that the US is heading towards a recession. If not that, then at least a period of very slow growth that will surely feel exactly like an actual downturn. All the signs are now there: employment is softening, jobless claims are rising, consumer spending is fitful, confidence is falling, and industry is showing signs of pulling back and hunkering down. The dollar has fallen by over 25% in two years and interest rates have been cut to offset the slowdown, but have not had the desired effect.

Paul Krugman adds gloom with this article today in the New York Times: Innovating Our Way to Financial Crisis

Those who argue that the financial crisis [and those words are used advisedly] is over, or is incidental to the rest of the economy, are missing the boat. The real impact of the sub-prime mess is not necessarily the actual capital losses that the banks incur, large though those losses are. It is the consequence: as Krugman points out, banks will have to pull back from lending for a while to rebuild capital, and the market has to lick its wounds while it figures out whether all those exotic financial instruments are really worth anything. So anyone – firm or individual – looking for money to support spending will be faced with a much sterner banking system over the next year or so. Credit will be tight. That will slow expansion as businesses who fail to get financing cut their workforces and so on. And consumers who are faced with tight credit will not be able to spend with the gusto we are used to seeing: since the US is a consumer economy and accounts for about 18% of total worldwide expenditure the sub-prime disaster will ripple abroad as well. Workers in far away lands will lose their jobs because America failed to act responsibly.

All of this will take time to pass over. We have not yet found the bottom of the mortgage losses: as Krugman mentions Florida has now found itself in a fiscal crisis because its teachers retirement fund was invested in sub-prime loans. How many other states have yet to come clean on similar situations? We don’t know, and as long as we don’t know the cloud of suspicion will prevent the financial markets from healing.

The loss of confidence needs decisive leadership from government: regulations need tightening, banking supervision needs an overhaul, and temporary support for sub-prime borrowers needs to be put in place quickly. What we don’t need is a bail out for the market players who fooled themselves: they need to pay the consequences of their folly and thus inject an air of responsible realism back into what had become a playground for inexperienced, overcompensated, desk jockeys masquerading as bankers.

Can we expect leadership? I fear not. We have a market biased ideology embedded in Washington. The notion that markets “know best” still pervades policy making even in the face of the evidence thrown up by the sub-prime mess.

It is this failure to learn the ideological lesson that makes me pessimistic about the near and medium term outlook for the US economy.

2008 looks like it will be a tough year.