Since the cracks that turned into earthquakes began convulsing the economy in the summer of 2007, pundits have actively debated both the depth of the financial downturn and its duration. More than $300 billion has been written down to date. Ultimately, losses could exceed $1 trillion.
The collective American wallet that for a generation had been stretched to the size of a suitcase because of rising asset prices and financial innovations has been zipped up. Consumer spending that represents about 70 percent of the gross domestic demand has slowed to a trickle because of the housing bust, the credit crunch, higher food and fuel costs, a weakening labor market, a low savings rate and declining disposable income.
Both the Treasury Department and the Federal Reserve have taken unprecedented steps to contain the financial meltdown. The actions and statements of Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke undermine Alan “Dr. Pangloss” Greenspan’s snake oil optimistic assessment that “this is the best of all possible worlds.”
The markets, left to their own devices, can hedge and shift risk to those best able to assess risk, said the previous Fed chairman, and the market can discipline decision-making.
To the contrary, mounting evidence shows that “irrational exuberance” encouraged irresponsible leverage, blind reliance on the judiciousness of the rating agencies, and investments in highly toxic derivative securities.
Paulson and Bernanke have taken many unprecedented steps to stop the downward financial cycle and arrest inflation:
* Lent money directly to the investment banks and permitted them to post collateral for Fed loans, including hard-to-sell financial instruments backed by mortgages.
* Gave Fannie Mae and Freddie Mac direct access to the Fed.
* Promulgated sweeping regulatory changes to shore up mortgage lending practices.
* Altered the power and scope of regulatory bodies.
* Encouraged massive liquidity infusions to beleaguered institutions.
Critics worry that the nation’s mortgage problems could spill over to credit card loans and the high-yield debt market and ultimately cause a severe credit crunch for Main Street.
Paul Volcker, Fed chairman from 1979 to 1987, roundly criticized the central bank’s extraordinary response to the financial crisis in an address before the Economic Club of New York.
“The Federal Reserve judged it necessary to take actions that extended to the very edge of its lawful and implied power,” he said, “transcending certain long embedded central banking principles and practices.”
Volcker believes that a currency draws its strength from the balance sheet of the central bank. He decries the Fed’s sacrifice of the quality of its own balance sheet. In June 2007, Treasury securities constituted 92 percent of the Fed’s earning assets in stark comparison to today’s 54 percent.
The origins of this crisis lie in the biggest asset bubble in history. Financial markets have already suffered arguably their biggest shock since the Great Depression.
What has prevented a full-blown economic tailspin?
* Congress quickly initiated a fiscal stimulus program.
* The Fed slashed interest rates.
* The Federal Reserve has extended a safety net to investment banks, mortgage institutions and government sponsored enterprises Freddie Mac and Fannie Mae.
* Global demand, coupled with a weak dollar, is boosting American exports.
The main fear is that exporters, such as the Gulf States or the Asian bloc countries that peg their currencies to the greenback, will suffer a combination of reduced demand and high inflation. Simply stated, the American downturn could become a world depression.
How would a U.S. recession impact the next president?
* Big domestic reforms, such as expanding health-care coverage, will become more difficult.
* With a fragile economy, the Democrats, if they get in, may have to rethink their plan to roll back George Bush’s tax cuts, thus exacerbating our huge budget deficits.
Many Americans worry that our country is on the wrong track. The momentum to re-regulate financial markets, punish the oil industry, credit-card firms or indeed any other malefactors of great wealth has grown.
In conclusion, Bernanke and Paulson have toiled relentlessly over the past 12 months to stem the leaks in the financial dikes.
“The financial turmoil is ongoing, and our efforts today are concentrated on helping the financial system return to more normal functioning,” Bernanke said. “It is not too soon, however, to begin to think about the steps we might take to reduce the incidence and severity of future crises.”
Originally published in the Sarasota Herald-Tribune
