Sebastian Mallaby on Team Obama and the Economic Crisis

By Sebastian Mallaby
Monday, November 24, 2008

Not a moment too soon, Barack Obama's economic team is taking shape. After a horrendous week on Wall Street, the leaked news of Tim Geithner's nomination as Treasury secretary sparked a wild rally on Friday; the weekend brought word that Larry Summers would take the top economic job at the White House, while Obama devoted his Saturday radio address to the promise of a large stimulus. But the new team needs to keep forging ahead. The financial hurricane has done the impossible and grown worse. Geithner and Summers cannot wait until January to come up with further remedies: Obama is in danger of seeing his presidency wrecked before he even takes office.

The financial crisis has morphed into several simultaneous crises that feed upon each other. The real estate bust crippled the banks. Crippled banks starved companies of credit. Starved companies laid workers off. Laid-off workers defaulted on mortgages, deepening the bust in real estate. By a similar process, crippled financial institutions stopped making auto loans, which caused people to stop buying cars, which pushed the carmakers to the brink. If the carmakers go down, a whole new round of job losses and mortgage defaults will slam into the financial system.

Because of these terrifying feedback loops, problems that were supposed to have been fixed are now back with a vengeance. It was a shock a year ago when the mighty Citigroup admitted to vast losses on subprime mortgages. Then Citi raised billions in new capital, and as recently as September it felt strong enough to bid for Wachovia, a bank with $700 billion in assets. But because home prices are still falling and default rates are rising, the billions Citi raised turn out not to be enough. Having announced it would cut 75,000 jobs, Citi looks likely to be the next bank to get a government bailout.

Dozens of banks, hundreds of companies and millions of households are potential Citis. All have planned their future on the assumption that assets are assets, not some kind of empty hologram. Yet, in the course of this crisis, an estimated $11 trillion in household wealth has been wiped out. Home values, 401(k) retirement plans, brokerage accounts -- poof, gone. It's hardly surprising that traumatized consumers are boycotting the stores, threatening yet more bankruptcies and losses for the banks.

Meanwhile, the crisis has gone global. As recently as September, Brazil's president could say, "People ask me about the crisis, and I answer, 'Go ask Bush.' It is his crisis, not mine." But today nearly every emerging market is in trouble, no matter whether it is an oil exporter or an oil importer, a manufacturer of electronics or a miner of copper. Each country's distress damages the export prospects of the next one. The vicious cycle spirals downward.

In an ordinary downturn, central banks have little difficulty breaking the fall. In 2001, for example, the Fed's interest rate cuts offset the technology bust by stimulating home construction. But this is no ordinary downturn. The Fed has already slashed interest rates and taken unprecedented steps to backstop the financial system. Congress has passed a fiscal stimulus and authorized the Treasury's $700 billion bank rescue plan; Fannie Mae and Freddie Mac, the two housing finance giants, have been effectively nationalized. But although U.S. policymakers have done more in less time than any economic team in history, they are nonetheless behind the curve. And every time they hesitate, the markets dive deeper.

The euphoric Wall Street rally that greeted the Geithner nomination underlined how investors are desperate for leadership. By promising a truly massive stimulus, Obama has shown he understands the need to change the psychology and break the downward spiral. But it will take time for the stimulus to feed its way into the economy, and Obama needs to come up with interim medicine that acts faster. The most promising option involves working quietly with the Fed -- something that Geithner, the Fed's outgoing New York chief, is well positioned to accomplish.

The Fed has the power not only to cut short-term interest rates but also to force long rates down. Imagine a class of mortgage securities that cost $100 and pay out $6 in interest annually, meaning that the interest rate is 6 percent. The Fed could announce its willingness to buy all such securities for $150, driving the interest rate down to 4 percent. The moment it did this, the value of banks' mortgage portfolios would leap, because the Fed would now be offering to buy them at a premium; meanwhile, families could fix their finances, because mortgage rates would be lower. The catch is that to buy all those mortgages, the Fed would have to print money, which could eventually cause inflation. And assuming some of the mortgages defaulted, the Fed's action would burden the budget, something it would be reluctant to do without approval from the new team at Treasury.

Calling upon the Fed to print money is radical. But desperate times demand creative remedies. Fortunately, Obama has chosen to surround himself with experienced technocrats -- pragmatists who excel at imaginative improvisation.

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