Because rising sovereign yields have been accompanied by narrower spreads on riskier debt, such as lower-grade corporate bonds, this is plausible.

TO BE NOTED: From The Economist:


Government debt

The big sweat

Jun 11th 2009 | WASHINGTON, DC
From The Economist print edition

Banking catastrophes and recession have led to vast increases in rich countries’ public debts. Getting their finances back into shape will be painful

Illustration by Daniel Mackie

OVERINDULGENCE has a price. After years of scoffing food and swilling booze, the cost is physical. After a debt-fuelled financial bender, it is fiscal. Governments have been propping up the world economy with a borrowing spree of their own. The recession has drained tax revenues and policymakers have been spending unprecedented sums to get their economies going and support their banks. Sovereign debt is piling up.

According to a study by economists at the IMF, published on June 9th, by next year the gross public debt of the ten richest countries attending the summits of the G20 club of big economies will reach 106% of GDP, up from 78% in 2007. That translates into more than $9 trillion of extra debt in three years.

There is more to come. Because economic growth is likely to be weak for several years after the recession ends, especially in countries such as America and Britain where over-indebted consumers must rebuild their savings, budget deficits will remain big. The IMF economists’ baseline is that the government debt of the rich ten will hit 114% of GDP by 2014. Under a darker scenario in which economies languish for longer while fears about governments’ solvency push interest rates up, the debt ratio could be 150% (see chart 1).

Governments have never borrowed so much in peacetime. Their huge debts will shape the world economy for a decade. In the short term the extra borrowing is prudent: governments must expand their balance-sheets to counter the savage pace at which firms and households are cutting back. Were governments not stepping in, the private shift to thrift would be causing an even deeper recession. Tax revenues would fall by more, banks would be even wobblier and public borrowing might end up even higher.

So far, the flight from risk that has made government intervention necessary has also minimised its cost. Investors have flocked to the safety of government bonds, allowing sovereign borrowers to raise money cheaply. Although yields have risen this year, governments in most big economies are still paying less than they were when the crisis began in 2007 (see chart 2).

The real questions concern the medium term. How much damage will greater indebtedness do to economic growth and governments’ creditworthiness? Borrowing on today’s scale is plainly unsustainable, but will the rich world’s governments be able to contain their debt burdens through budgetary discipline alone, or will they be tempted to turn to inflation or even forced to default? An assessment of these risks requires a look at the crises of the past, the financial markets of the present and the timeless arithmetic of debt.

History suggests that a big build-up of public debt is all but inevitable given the magnitude of the recent crash. A study of 14 severe banking crises in the 20th century by Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard University shows that public debt rises by an average of 86% in real terms in the years after big financial busts, as economies flag and governments are forced into serial attempts to revitalise them.

Default or high inflation are common. In the 1930s even America and Britain changed the terms of their government debt. America abrogated the “gold clause” (which fixed the payment of interest and principal in terms of the metal) after leaving the gold standard. Britain restructured the terms of some war bonds. The debt burdens of Germany after the first world war and Japan after the second were slashed by hyperinflation.

Since the 1940s no advanced economy has defaulted on its bonds (though numerous emerging ones have). And many rich-world governments have been able to lighten their debt burdens without resorting to high inflation. Britain’s public-debt ratio soared to 250% of GDP as a result of the second world war and America’s exceeded 100%. Both fell sharply in later decades, thanks largely to fast growth.

In the past 20 years several smaller rich economies, including Canada, Denmark and Ireland, slimmed their public debt by 40% of GDP or more as economic growth accelerated and budgets were kept tight. Ireland was conspicuously successful: in 1987 its gross debt was 109% of GDP; by 2007 it was down to 25%. Another smallish country, Sweden, proved that public finances can bounce back quickly from a banking bust. In the early 1990s its government-debt burden went up from 40% of GDP to more than 70%, but fell to below 50% by 2000.

Alas, there are plenty of reasons why a quick rebound will be harder today. The number of countries involved makes it less likely that any of them can count on exports to boost their economic recovery, as Sweden did. Because households will need to save much more and growth may be sluggish for several years, Japan may be a more relevant precedent. Years of stagnation after its property bubble burst have almost tripled Japan’s public-debt ratio, from 65% of GDP in 1990 to more than 170% now.

Governments can no longer rely on some forces that aided a return to fiscal fitness in the past. During the second world war capital could not flee, and governments controlled prices and could appeal to patriotism. Now they must make their case in global capital markets. More recently Ireland and others were helped by steep falls in interest rates. With rates already low, that bonus will not recur.

Nor is the financial crisis the only cause of budgetary strain. In America, for instance, Barack Obama’s administration has ambitious plans for broader health-care coverage, though it promises to pay for it. Worse, the biggest peacetime jump in the rich world’s public debt is taking place just before a slow, secular collapse in most countries’ public finances as workers age and the costs of health care rise. According to the IMF’s calculations, the present value of the fiscal cost of an ageing population is, on average, ten times that of the financial crisis. Left unchecked, demographic pressures will send the combined public debt of the big rich economies towards 200% of GDP by 2030.

The sheer scale of their fiscal burdens may tempt governments to lighten their loads by inflation or even outright default. Inflation seems increasingly plausible because many central banks are already printing money to buy government bonds. To fiscal pessimists this is but a small step from printing money simply to pay the government’s bills. Adding to their worries, many economists argue that a bout of modest inflation would be the least painful way to ease the financial hangover.

The rich world’s build-up of debt may also cause changes in countries’ relative creditworthiness. Investors have long viewed emerging economies as riskier sovereign borrowers than rich ones, because of their history of macroeconomic instability and more frequent defaults. But the biggest emerging economies are now by and large in better fiscal shape than their richer fellows, and that discrepancy is set to widen. The emerging members of the G20 had a ratio of public debt to GDP of 38% in 2007. By 2014, says the IMF study, this is likely to fall to 35%, less than a third of the rich world’s average. As a result the gap between the yields investors demand from rich and emerging economies’ bonds is likely to narrow.

Measuring market pressure

Uncertainty about all this has been evident in bond markets (and, somewhat erratically, in the prices of sovereign credit-default swaps: see article). Although yields are broadly low, prices have been volatile. Earlier this year the markets’ fears were focused on weaker members of the euro area, notably Greece, Ireland, Portugal and Spain. In mid-March yields on long-term Greek and Irish government bonds hit 6%, almost twice that on German bonds. Without their own currencies these countries cannot unilaterally inflate away their debt, so the worry lies in the increased risk of default. All four have had their debt downgraded by the big credit-rating agencies. Ireland was marked down again by Standard & Poor’s on June 8th.

Lately markets have also been paying attention to America and Britain. Standard & Poor’s put a negative outlook on Britain’s AAA rating last month. Yields on American Treasury bonds have risen sharply. On June 10th the yield on ten-year bonds came within a whisker of 4%; late last year it was not far above 2%. Ben Bernanke, head of the Federal Reserve, has attributed some of this increase to concerns about America’s fiscal future. But much of it, he believes, is due to an ebbing of the panic that sent investors rushing to buy government debt last year. Because rising sovereign yields have been accompanied by narrower spreads on riskier debt, such as lower-grade corporate bonds, this is plausible.

Investors’ uncertainty is not surprising. To gauge governments’ ability and willingness to carry debt burdens, they must apply both the laws of arithmetic and less precise political and economic calculations. Arithmetically, a government’s debt burden is sustainable if it can pay the interest without borrowing more. Otherwise the government will eventually fall into a debt trap, borrowing ever more just to service earlier debt. In practice merely stabilising debt ratios at a higher level may not be enough, because extra public debt crowds out private investment and drags down long-term growth. A better goal is to work off big increases in debt. How difficult that is depends on the size of the debt, the pace at which the economy grows and the interest rate the government must pay.

Suppose a country’s gross public debt is 100% of its GDP. If the economy grows by 4% in nominal terms and long-term interest rates are 5%, the government will need a primary budget surplus—ie, before interest payments—of 1% of GDP to keep its debt ratio unchanged. To work off a rise of ten percentage points in the debt ratio over ten years requires an additional percentage point on the primary surplus.

This arithmetic suggests that the projected 36-point rise in indebtedness between 2007 and 2014 should not in itself be a calamity. It also implies that countries which entered the financial crisis with modest burdens have more room for manoeuvre than those already deeply in debt. Some of the hardest-hit countries, such as Ireland and Spain, began with low debt ratios, making default extremely unlikely, at least in the short term. Italy and Japan were hemmed in from the start. America met the crash with a gross debt ratio of just above 60% of GDP. Germany’s ratio was similar and Britain’s a bit lower (see table 3).

Gross debt is a good measure of the public sector’s demands from financial markets, since it includes all outstanding government paper. It is the measure used in the IMF study. But it does not give a full picture. Some countries include internal government IOUs in their figures: America, for instance, counts the bonds held in its government pension plan. Because other countries do not, that overstates America’s relative gross debt burden. Washington policymakers prefer to look at “debt held by the public”, which excludes those internal IOUs. At 37% of GDP in 2007, it puts America in a better light.

Although gross debt is the best guide to governments’ financial obligations, net debt, which subtracts the value of their assets, is a better indicator of their creditworthiness. The difference can be huge. Norway’s gross debt was close to 60% of GDP in 2007, but thanks to its oil-based sovereign-wealth fund it had a net surplus of almost 150% of GDP. Since Japan’s government controls vast assets, notably the Japan Post bank, its net debt, at 86% of GDP, is far lower than its gross debt. After financial crises, the gap can widen a lot. When governments take over failed banks their gross debt soars, but because the accompanying assets have value net debt goes up by much less. Comparing net debt across countries is harder than comparing gross debt, because estimating the value of government assets is hard. Even so, the ranking of big rich economies’ burdens, and of the likely increases in them, is much the same on both measures.

Furthermore, calculations about the sustainability of debt must take into account more than just its size relative to GDP. As a rule, countries that issue debt in their own currency to their own citizens are less vulnerable than those that must sell bonds in foreign currencies or that depend heavily on foreign lenders. Emerging economies, which have usually borrowed from abroad, have often faced crises with debt burdens of less than 60% of GDP. Japan, with a large pool of private domestic savings, funds a debt burden almost three times as big as that easily—and cheaply. Persistent economic weakness has pressed yields on Japanese government bonds down from 7% in 1990 to below 2%.

This gives some comfort to rich countries with rising debt burdens—especially America, because the dollar is the world’s reserve currency. The rise in private saving after the financial crisis should also hold down the cost of borrowing. That said, America, like Britain and many other countries but unlike Japan, relies on foreign investors, who may prove less willing to fund a much larger debt burden. In the past a bigger burden in America has led to slightly higher long-term interest rates. One often-cited study suggests that a rise of ten percentage points in the ratio of debt to GDP increases long-term bond yields by a third of a percentage point. If America’s debt burden gets a lot bigger, however, this could change. Studies from continental Europe suggest that the extra interest-rate cost rises with indebtedness.

The budget balance, which indicates the prudence of fiscal policy from year to year, also helps in determining a government’s vulnerability. On that measure the economies of the euro zone fare relatively well. Germany, for instance, entered the crisis with a primary surplus. Both Britain and America had deficits.

From prudence to profligacy

Unfortunately, some countries that seemed to be in decent shape, such as Ireland and Spain, turn out to have relied too much on revenues from soaring property prices and have seen their tax bases collapse. The IMF’s economists reckon that by 2014 Ireland’s gross public debt is likely to exceed 120% of GDP, undoing all the gains from the past two decades, while its primary deficit will still be 6.7% of GDP. In Britain, which counted on taxes from financial assets and property, the primary deficit is still likely to be above 3% of GDP in 2014, one of the highest among the world’s big rich economies.

Illustration by Daniel Mackie

All this is daunting enough. But for a full sense of the task facing governments, demographic pressures have to be added to the crisis-related damage. On this score all the world’s big rich economies are in trouble, but some are worse placed than others—which implies that they will have to run bigger primary budget surpluses. The present value of the increase in America’s future age-related budget obligations is about five times its GDP. For Britain, the figure is about three times.

To estimate just how much pain lies ahead, the IMF’s economists put all these elements together, assume that long-term interest rates exceed economic growth rates by a percentage point (the long-term pre-crisis average) and then calculate by how much primary budget balances would have to improve in order to bring gross debt ratios to a sustainable level. The economists define this level as 60% or, for Japan, half of today’s figure (ie, 85%). Their results suggest that Ireland and Japan have most to do. Both would need to boost their primary balances by more than 12% of GDP, compared with what is forecast for 2014. Britain would need an improvement of close to 6%. The gap in America is 3.5% and in Germany just under 2%.

All told the outlook is bleak. In a few countries, the financial crisis has badly damaged the public finances. Elsewhere it has accelerated a chronic age-related deterioration. Everywhere the short-term fiscal pain is much smaller than the long-term mess that lies ahead. Unless belts are tightened by several notches, real interest rates are sure to rise, as will the risk premiums on many governments’ debt. Economic growth will suffer and sovereign-debt crises will become more likely.

Somehow, governments have to avoid such a catastrophe without killing the recovery by tightening policy too soon. Japan made that mistake when concerns about its growing public debt led its government to increase the consumption tax in 1997, which helped to send the economy back into recession. Yet doing nothing could have much the same effect, because investors’ fears about fiscal sustainability will push up bond yields, which also could stifle the recovery.

The best way out is to tackle the costs of ageing head-on by, for instance, raising retirement ages further. That would brighten the medium-term fiscal outlook without damaging demand now. Broadly, spending cuts should be preferred to tax increases. And rather than raise tax rates, governments would do better to improve their tax codes, broadening the base and eliminating distortive loopholes (such as preferential treatment of housing). Other priorities will vary from one country to the next. But after today’s borrowing binge, doing nothing is no longer an option."

challenge this time around consequently will be to bring down the government’s borrowing as private borrowing resumes

TO BE NOTED: From Follow The Money:

"More on the fall in private borrowing and the rise in the fiscal defict

Posted on Tuesday, June 2nd, 2009

By bsetser

The chart that supported my previous post attracted a fair bit of attention. But it was cobbled together at home and only looked at data over the past few years. With help from the CFR’s Paul Swartz, I looked at the quarterly data over a longer time period.

The story is clear. Government borrowing has increased dramatically. It topped 15% of GDP in the last two quarters of 2008. In 2007 and early 2008 it was more like 3% of GDP. But private borrowing has fallen equally sharply. Total borrowing by households and firms fell from over 15% of GDP in late 2007 to a negative 1% of GDP in q4 2008.

Negative borrowing by households and firms means, I think, that households paid down their debts in the fourth quarter.

It hardly needs to be noted that the fall in borrowing by households and firms in late 2008 was exceptionally rapid. A stronger economic cycle implied that the magnitude of counter-cyclical fiscal policy also needed to be ramped up.

The disaggregated data on borrowing by households and firms is also interesting. Household borrowing rose to record levels in 2003 and remained high through early 2006. Household borrowing fell in 2007, but for a time this fall was offset by a rise in borrowing by private firms. Borrowing by firms actually peaked in the middle of 2007 at a higher level than during the dot come investment boom. Chalk that up to a surge in leveraged buyouts and stock buybacks.

Both charts highlight the risk that worries me the most. In both the early 1980s and the first part of this decade, both the private sector and the government were large borrowers. And in both cases, borrowing rose faster than domestic savings, so the gap was filled by borrowing from the rest of the world. The trade and current account deficit rose. In the early 1980s, the US attracted inflows by offering high yields on its bonds. More recently, it did so by borrowing heavily from Asian central banks, together with the governments of the oil-exporting countries. But now yields are low (even after the recent rise in the yield on the ten year Treasury bond), and need to be low to support a still weak US economy. And China (and others) are visibly uncomfortable with their dollar exposure; banking on their continued willingness to finance a large external deficit seems like a stretch.

The challenge this time around consequently will be to bring down the government’s borrowing as private borrowing resumes.

Update: Household, household and government and total borrowing over time on a rolling four quarter basis:

And the quarterly data.

All data comes from table F1 of the flow of funds.

The downturn in total borrowing in the rolling four quarter sum reflects a low level of total borrowing in the second quarter (i.e. before government borrowing ramped up both to fund the fiscal deficit and to finance the financial sector). But even in the fourth quarter of 2008, total borrowing wasn’t up …"

harder for smaller-capital companies and start-ups to obtain financing, and could lead to institutional advantages for incumbent, large-cap companies

TO BE NOTED:

---

May 11, 2009, 4:46 pm

Shift to Thrift: How Will Americans Save?

By Catherine Rampell

On Sunday I had an article about how many economists expect the days of zero or negative personal savings rates to be over, at least for a while.

While painful in the short run (since consumer spending makes up 70 percent of gross domestic product), a more lasting shift to saving could be good for the economy. More savings → more investment → more capital for American companies → greater economic growth → higher living standards.

This logic assumes, however, that Americans will be saving through financial institutions, rather than their mattresses. And even within financial institutions, their investment options are likely to evolve.

Historical research has found that people who live through a period of low stock market returns (and presumably declines, in the case of the last year) are less willing to invest in stocks, and instead prefer safer, lower-return investment alternatives like bonds. (Aside: On the other hand, people who lived through high-inflation periods tend to be wary of investing in long-term bonds.) More recent financial experiences also tend to have a stronger impact on these long-term attitudes toward investment decisions, according to the study’s authors, Ulrike Malmendier at the University of California, Berkeley, and Stefan Nagel at Stanford.

What does all this mean for near-term savings behavior?

“People are probably going to be thinking more along the lines of ‘How do I generate safe and secure retirement income?’ instead of ‘How do I amass the biggest balance in my account?’” said William Gale, director of both the economic studies program at Brookings Institution and the Retirement Security Project. Workers can invest their retirement savings in (among other things) stock funds, bond funds and annuities, and Mr. Gale expects there to be much more interest in the latter two categories.

Already it appears that financial institutions like Fidelity are developing more products for investors who “are seeking more conservative investment options.”

A shift to lower-risk saving opportunities may result in more secure retirement funds, but it has mixed implications for economic development.

“We may have lost a generation of investors,” said Joseph Brusuelas, a director at Moody’s Economy.com. “People may now look at the stock market as a losing proposition, as some sort of Wild West where the undeserving become rich, and those who play by the rules end up losing.”

This could make it harder for smaller-capital companies and start-ups to obtain financing, and could lead to institutional advantages for incumbent, large-capital companies, he said."

driven down saving yields

From News N Economics:

"Fed measures killed the yield on household saving

Saturday, April 25, 2009

A reader of this blog expressed concern about the effects of the Fed's massive expansionary efforts on the value of household saving. Specifically, the Fed slashed its fed funds target 510 bps from 5.25% in September 2007 to 0%-0.25% in December 2008, which has likewise driven down saving yields. Tom Petruno at the LA Times wrote a piece to this effect:

Who's really bailing out the banks?

Taxpayers, for sure. But the largely unsung victims of the financial system rescue are loyal bank depositors -- especially older people who have relied on interest income from savings certificates to live.

To save the banks from soaring loan losses, the Federal Reserve did what it always does when the industry gets into trouble: Policymakers hacked their benchmark short-term interest rate, which in turn pulled down all other short-term rates, including on savings vehicles.

But this time the Fed went to rock-bottom on rates. In December, the central bank declared that it would allow its benchmark rate to fall as low as zero.

Savers still are paying the price for that gift to the banks. Average rates on certificates of deposit nationwide have continued to slide this year, according to rate tracker Informa Research Services in Calabasas.

The average yield on a six-month CD fell to 1.27% this week, down from 1.86% on Jan. 1 and 2.24% a year ago. Anyone who has a CD maturing soon should be prepared for serious sticker shock.

Banks have been able to continue whittling down savings yields because the industry overall is flush with cash -- not just from the Fed's efforts to pump unprecedented sums into the financial system, but also because the events of the last year have left many people too afraid to keep their money in anything but a federally insured bank account. At least you know your principal is guaranteed.

Even as short-term interest rates have dived since the financial crisis exploded in September, the total sum in CDs under $100,000, as well as savings deposits and checking accounts, has soared by $507 billion, to $6.07 trillion, according to data compiled by the Fed.

RW: In spite of the rock bottom rates on saving accounts, CDs, and money market mutual funds, households continue to flock to the safety of these insured funds. And in response to increasing demand for saving instruments - the personal saving rate rose from 0.3% in February 2008 to 4.2% one year later - banks will draw down yields further.

Buy what Tom doesn't' say is that rock-bottom rates are here to stay. According to the FOMC statement:

"economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

And how long is that? Well, recently the Bank of Canada, whose interest rate policy tends to move in sync with the Fed's, released its monetary policy statmement. The BoC cut its overnight rate target to 0.25%; but more importantly, it made a definitive statement of how long might be an extended period:

"Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target."

It looks like saving rates will be low for a while, folks. The massive economic contraction is dragging down prices, and the IMF is forecasting U.S. deflation throughout 2010 (see Table A5 in the World Economic Update). Using the BoC's statement as a proxy for extended period, the near-zero federal funds target will hold saving yields low until June 2010, fourteen more months from now.

Disclaimer: To me, deflation remains to be a mechanism to clear markets rather than a macroeconomic hindrance. And furthermore, the IMF's outlook is very gloomy. Clearly, with 0% growth in 2010 for both the U.S. and the sum of advanced economies, the IMF expects an onslaught of defaults that are already in the pipeline, defaults that are not currently priced into market activity. We will see, though. The World Bank is projecting 2% U.S. growth in 2010.

Rebecca Wilder"

Me:

Don said...

"It looks like saving rates will be low for a while, folks."

I hate to be the person always sounding paradoxical, but the response from people that we want is to for them to find the low rates unacceptable and to start to go looking for riskier and higher yielding investments. That's how you conquer the fear and aversion to risk.

The added risk is, in fact, investment in forward looking projects that are unusually scary in a downturn. Presumably, that's the rationale for government investing during a downturn. Those of us who like private investment better than government would prefer individuals to start accepting more risk in investment.

Since many businesses don't make it, investing under our system is always risky. That's why we need risk. I'm not an investor, but I'd look into corporate bonds.

Don the libertarian Democrat

April 25, 2009 11:54 AM"

double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other

TO BE NOTED: From The Growth Blog:

"The Financial and Economic Crisis and the Developing World: Where We Are and Where We Are Going

By Michael Spence

Created 04/14/2009 - 16:46

The financial system in the USA and much of Europe had a heart attack in September 2008. As in the case of a real heart attack, the highest priority has gone to the emergency response and to stabilizing the patient. Once that is done and the crisis is abating and even to some extent as it is going on, it will be important (economically and politically) for some to focus on two related issues: What created the rising risk of an attack? And what combination of actions post-crisis will reduce the risk of a repeat in the future.

There are related issues. Are there lessons in the current crisis (and past ones) or is each one sufficiently idiosyncratic so that reregulating with reference to the past does little to limit the potential future damage. Globally, what is the appropriate tradeoff between risk reduction on the one hand and higher costs of capital and lower growth on the other? Is the financial sector different from most others in that when it malfunctions, the rest of the economy malfunctions along with it, and if so should it be treated differently? Will investors learn from this crisis to a point that much of the “re-regulation” will come from adjusted investor behavior and risk assessment procedures? Or are there inherently large divergences between private and social objectives that need to be aligned through regulatory and oversight structures? Are the answers the same for domestic economies and financial systems and for the global aggregate, or are they fundamentally different?

In climate change there are issues of mitigation (prevention or risk reduction) and adaptation. Good policy is a mix of the two. Corner solutions are unlikely to be the right answer. A similar issue arises in the present case. Whether or not regulation and oversight are adequate depends upon the risks and the consequences of financial instability and distress and the latter depends on the existence and effectiveness of response mechanisms. We will need to talk about both in a coordinated way.

The Crisis of September 2008

Credit locked up, interbank lending stopped, and the payments systems' started to malfunction in the US and much of Europe. The TED spread (The interest rate differential between t-bill rates and LIBOR) and related measures of risk at the heart of the financial, payments and credit system rose from its normal 100 basis points to between 4 and 5 hundred basis points. Asset prices declined rapidly, balance sheets in the financial sector further deteriorated and the household sector experienced a massive wealth loss, triggering a reduction in consumption. The double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other accelerated and has only recently shown evidence of deceleration.

The financial crisis quickly became an economic problem and then a crisis. Asset price declines (equities globally lost $25-30 trillion or more in a four month period) and very tight credit caused investors and consumers to become extremely cautious, causing consumption to fall and the real economy to turn downward. There was no near-term bottom and few brakes to slow the downward momentum.

A complete credit lock-up (and a depression-like scenario in which businesses that rely on credit simply fail) was averted through rapid action by central banks using a growing variety of programs to increase liquidity or directly supply credit, thereby circumventing the normal channels that were damaged and not functioning. The balance sheet of the Fed more than doubled in size from less than a trillion to more than two trillion and with recent commitments is on its way to 3 trillion dollars.

There were two further issues of central importance. First, the markets in a variety of securitized assets stopped functioning. The shadow banking system through which a substantial portion of credit is provided in the US, froze up. Second, because of a combination of leverage and damaged assets, there was and is a potentially large solvency problem in a significant number of large and systemically important institutions. The solvency and related transparency issues continue to be with us today.

The effects on the developing world were immediately felt, though the awareness of the magnitude increased over time. The two important channels were aggregate demand (globally), and the availability and cost of credit and financing. A third channel, rapid shifts in relative prices apart from credit spreads, were important but on balance beneficial.

The financial channel was dramatic. Credit tightened pretty much instantly in the developing world as capital either rushed back to the advanced countries or stopped flowing out, to deal with damaged balance sheets and capital adequacy problems in the advanced countries. The currencies of all major developing countries except for China depreciated against the dollar. Developing countries with reserves used them to stabilize the net capital flows and to partially restore credit and financing. Trade financing dried up and other capital flows diminished or disappeared. The IMF intervened in several cases while financing and bilateral swap arrangements of a variety of kinds were made by the US and China. Credit remains tight and high priced and there is a continuing need for additional financing on a broad front. The IMF did not have the resources in the fall of 2008. Expanding those resources significantly was part of the G20 agenda. At the G20 summit in early April, an important commitment was made to expand IMF resources by over $1 trillion to restore the availability of trade and other forms of finance on an interim basis to developing countries that need it.

The second channel was aggregate demand and trade. As aggregate demand in the advanced countries dropped for the aforementioned reasons, global aggregate demand fell and with it trade: exports and imports. The trade data show a stunning drop in exports, considerably more than in aggregate demand. In many developing countries that rely on external demand and exports as an engine of growth, the immediate negative effect was lower growth, reduced employment and reduced consumption triggering the usual domestic recessionary dynamics.

Globally, the intent is to counter this loss of aggregate demand with coordinated fiscal stimulus programs in the advanced countries and in developing countries to the extent it can be done without jeopardizing fiscal sustainability. The latter capacity varies considerably across countries. There is dissension in the G20 as to what the right order of magnitude is. There are also issues of free riding and protectionism. It is understandable that citizens in various countries facing fiscal deficits and large future debt service obligations prefer to have the benefits of a stimulus program land domestically.

I have described this incentive structure elsewhere as akin to a prisoner’s dilemma with the non-cooperative dominant strategies being either stimulus with some protectionism or free-riding depending on the size and openness of the economy. One can think of that portion of the G20 effort, the part devoted to openness, as attempting to shift policies away from the non-cooperative Nash equilibrium. Evidently, from data on increases in protectionist measures, this will be only partially successful, but partial success is probably much better than no effort at all. Realistically we may not have the option of choosing the first best, coordinated stimulus with openness, but rather have to be satisfied with an effort at coordinated stimulus with some protectionism, as opposed to openness with feeble stimulus commitments.

More generally there is confusion and disagreement about the role of government in the context of a crisis. I have written at somewhat great length about this issue here [1]. This disagreement complicates the politics of timely and effective intervention and has to be factored into the risk assessments for policy makers and private investors and consumers alike. One thing is clear. Government has become a major player in the financial system and the economy. In the financial system it has morphed from regulator to regulator and participant. Predictability of government action has therefore become a major determinant of risk.

The third channel was relative price changes. The dramatic spike in commodity prices (especially food and energy) was reversed. This ameliorated a twin challenge in most developing countries of dealing with the impact of the commodity price spike on the poor and on inflation. Beyond that, at the country level, those who have gained and lost depends on whether a particular country is a net importer or exporter of commodities.

The commodity price spike and fall brought into focus an important policy issue. Large relative price swings have very important distributional consequences across countries and across subsets of the population within countries. These need to be addressed as part of creating a better managed and more stable global economic system that people will support. [for further reference, see part IV of the Commission on Growth and Development: The Growth Report [2]].

Where Are We Now?

On the real economy side, in the advanced countries and globally, growth has gone negative or slowed dramatically. Global growth is projected to be negative in 2009 for the first time since World War II. Trade has collapsed. While there are some signs that the downward momentum may be slowing, the real economies have not bottomed out and are unlikely to do so in 2009 and perhaps well into 2010.

The advanced countries financial systems have shown some recent signs of improvement, though they are still functioning on life support. There are signs that credit is easing and risk spreads are declining somewhat from very high levels. But that is certainly because the government and central banks have a major and expanding role in the financial system. It is too early to say that the system is starting to return to normal. In the US, the Fed and the Treasury have launched a series of initiatives designed to restart the markets in securitized assets, clarify values, remove the transparency fog surrounding the balance sheets of major financial institutions, and as necessary recapitalize banks and other systemically important institutions, probably by becoming a major (or the sole) owner of some of them. Progress on this front from a policy point of view is relatively recent and it is too early to tell the extent to which they will be sufficient to jump start the sequential healing process and a return to normal functioning.

The US savings rate is rising, a part of the disorderly unwinding of global imbalances. Asset prices remain volatile and it is too early to tell if they have stabilized. It is clear however, that the financial system and the real economy will not return to their previous configurations. Even absent major and likely changes in regulation and oversight, there will be a “new normal”. Global growth in the future will be driven by a different portfolio of saving and investment rates and levels across countries.

The Growth Commission Workshop Meeting And Supplementary Report On The Financial And Economic Crisis

The Commission on Growth and Development is meeting one more time in late April in conjunction with a two day workshop, to consider issues related to the financial and economic crisis and its aftermath. The intent is to produce a special report, additional to the Commission report [3] which came out in May 2008. This special report will likely deal with three broad sets of issues.

One set has to do with post-crisis, the challenge of creating more effective regulatory and oversight structures (domestically and internationally) that reduce the risk of instability and the likelihood that the instability spreads quickly to the entire global system. A second set of issues has to do with crisis response. Are there ways when instability and malfunction occur, to limit the damage and disrupt the transmission channels? Further, can some of this capability be created in advance so that it can be deployed quickly? There is obviously a third issue: are the conditions needed to bring the patient back to health and prosperity being met? And if not, what else do we need to do?

The Commission anticipates that there will be a process overseen by the G20 designed to develop proposals for a different global financial architecture, regulatory and oversight structure. Our intention is to have the augmented Commission report contribute to that process with particular attention to the needs and interests of developing countries, some of whom are represented in the G20 itself and most of whom are not.

As we approach the workshop and the Commission meeting and discussion of these issues, we invite broader comment, input and discussion on the BLOG.

Like many members of the Commission and participants in the workshop, I have been thinking and writing about the financial and economic crisis under the headings of causes, crisis dynamics and policy responses, and post crisis reform. A link to my articles will be published on this blog, and I look forward to your comments."

The big decline in March sales was a disappointment

TO BE NOTED: From EconomPic Data:

"Retail Sales Fall (March)

WSJ reports:

U.S. retail sales unexpectedly plunged during March in a broad-based decrease that threw a shadow over recent signs of improvement in the slumping economy. Retail sales decreased by 1.1% compared to the prior month, the Commerce Department said Tuesday. Economists expected an increase of 0.3%.

Sales in February were revised up, increasing 0.3% instead of dipping 0.1% as originally reported. January sales were revised up to an increase of 1.9% from aan increase of 1.8%.

The big decline in March sales was a disappointment. The increases in January and February sales had temporarily ended a freefall in consumer spending during the second half of 2008. People seemed to be braving a pitiless job market and pulling out their wallets again, which is good for the economy. Consumer spending makes up 70% of gross domestic product, the broad measure of economic activity.

Source: Census

Posted by Jake at 6:13 AM

in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon

TO BE NOTED: From Naked Capitalism: These are my views too:

"Keynes' savings paradox, Fisher's debt deflation and the banking crisis

By: Paul de Grauwe

The world economy is experiencing a downward spiral in output and international trade that has not been seen since the Great Depression of the 1930s. The most striking feature of this downward spiral is the breathtaking speed at which industrial production, world trade and GDP is declining in the world since the end of 2008.

How can such a rapid deceleration of economic activity be explained? The answer has to do with different deflationary spirals that feed on themselves and amplify each other.

Four deflationary spirals

There are four deflationary spirals presently at work in the world economy, i.e. the Keynesian savings paradox, Fisher’s debt deflation, the cost cutting deflation, and the bank credit deflation. Each of these deflationary spirals can be dealt with when they occur in isolation. They become lethal when they interact with each other.

Keynesian savings paradox.

When one individual desires to save more, and he is alone to do so, his decision to save more (consume less) will not affect aggregate output. He will succeed to save more, and once he has achieved his desired level of savings he stops trying to save more.

When the desire to save more is the result of a collective lack of confidence (animal spirits) the individual tries to build up savings when all the others do the same. As a result, output and income decline and the individual fails in his attempt to increase savings. He will try again, thereby intensifying the decline in output, and failing again to build-up savings. There is thus a coordination failure: if the individuals could be convinced that their attempts to build up savings will not work when they all try to do it at the same time, they would stop trying, thereby stopping the downward spiral.

Somebody must organize the collective action. An individual agent will not do this because the cost of collective action exceeds his private gain.

Fisher’s debt deflation:

When one individual tries to reduce his debt, and he is alone to do so, this attempt will generally succeed. The reason is that his sales of assets to reduce his debt will not be felt by the others, and therefore will not affect the solvency of others. The individual will succeed in reducing his debt.

When the desire to reduce debt is driven by a collective movement of distrust, the simultaneous action of individuals to reduce their debt is self-defeating (Fisher(1933)). They all sell assets at the same time, thereby reducing the value of these assets. This leads to a deterioration of the solvency of everybody else, thereby forcing everybody to increase their attempts at reducing their debt by selling assets.

Here also there is a coordination failure. If individuals could be convinced that their attempts to reduce their debt will no work when they all try to do this at the same time, they would stop trying and the deflationary cycle would also stop. An individual, however, will have no incentive to organize such a collective action.

Cost cutting deflation

When one individual firm reduces its costs by reducing wages and firing workers in order to improve its profits, and this firm is alone to do so, it will generally succeed in improving its profits. The reason is that the cost cutting by an individual firm does not affect the other firms. The latter will not react by reducing their wages and firing their workers.

When cost cutting is inspired by a collective movement of fear about future profitability the simultaneous cost cutting will not restore profitability. The reason is that the workers who earn lower wages and the unemployed workers who have less (or no) disposable income will reduce their consumption and thus the output of all firms. This reduces profits of all firms. They will then continue to cut costs leading to further reductions of output and profits.

There is again a coordination failure. If firms could be convinced that the collective cost cutting will not improve profits they would stop cutting their costs. But individual firms have no incentives to do this.

Bank credit deflation:

When one individual bank wants to reduce the riskiness of its loan portfolio it will cut back on loans and accumulate liquid assets. When the bank is alone to do so (and provided it is not too big), it will succeed in reducing the riskiness of its loan portfolio. The reason is that the strategy of the bank will not be felt by the other banks, which will not react. Once the bank has succeeded in reducing the riskiness of its loan portfolio it will stop calling back loans.

When banks are gripped by pessimism and extreme risk aversion the simultaneous reduction of bank loans by all banks will not reduce the risk of the banks’ loan portfolio. There are two reasons for this. First, banks lend to each other. As a result when banks reduce their lending they reduce the funding of other banks. The latter will be induced to reduce their lending, and thus the funding of other banks. Second, when one bank cuts back its loans, firms get into trouble. Some of these firms buy goods and services from other firms. As a result, these other firms also get into trouble and fail to repay their debt to other banks. The latter will see that their loan portfolio has become riskier. They will in turn reduce credit thereby increasing the riskiness of the loan portfolio of other banks.

There is again a coordination failure. If banks could be convinced that the simultaneous loan cutting does not reduce the risk of their loan portfolio they would stop cutting back on their loans and the negative spiral would stop. They have no individual incentives, however, to engage in collective action.

The four deflationary spirals that we described have the same structure. The actions by economic agents create a negative externality that makes these actions self-defeating. This spiral is triggered by a collective movement of fear, distrust or risk aversion (animal spirits; see Akerlof and Shiller(2009) for a fascinating analysis). Individuals (savers, firms, banks) are unable to internalize these externalities because collective action is costly. There is thus a failure to coordinate individual actions to avoid a bad outcome.

Cyclical movements in optimism and pessimism (animal spirits) have always existed. Why do these now lead to such a breakdown of coordination?

The four deflationary spirals we identified, although similar in structure, are different in one particular dimension. The savings paradox and the cost deflation can be called “flow deflations”. They arise because consumers and firms want to change a flow (savings and profits). The other two involve the adjustment of stocks (the debt levels and the levels of credit). We call them “stock deflations”. Problems arise when the flow and stock deflations interact with each other.

In “normal” recessions such as the ones we have experienced in the postwar period prior to the present crisis, only the flow deflations were in operation. There had not been a preceding period of excessive debt accumulation and unsustainable levels of bank loans. As a result, households, firms and banks were not trying to adjust their balance sheets. The pessimism of households and firms was related to expected shortfalls in income and profits, and led to increased savings and cost cutting. In such an environment in which the stock levels were perceived to be right, there were sufficient automatic equilibrating mechanisms that prevented these two flow deflations from leading to an unstoppable downward spiral. The most important equilibrating mechanism occurred through the banking system.

When banks function normally they have a stabilizing force on the business cycle. The reason is that in a recession the central bank typically reduces the interest rate making it easier for banks to lend. In normal circumstances, when banks are not in the process of cleaning up their balance sheets, they will be willing to transmit this interest rate decline into a reduction of the loan rate. As a result, banks will engage in automatic “distress lending” to firms and households. Households will be less tempted to increase their savings. In addition, private investment by firms will be stimulated, i.e. firms will be willing to dissave, thereby mitigating the deflationary potential provoked by the savings paradox. (In De Grauwe(2009) I show this in the context of a simple IS-LM analysis).

The interest rate decline will also mitigate the cost cutting dynamics. This is so because it improves the profit outlook for firms, giving them lower incentives to go on cutting costs. Thus when the banking system functions normally, there are self-equilibrating mechanisms that prevent the flow deflations from degenerating into uncontrollable downward spirals.

The problem the world economy faces today is that flow and stock deflations interact and reinforce each other. The period prior to the crisis was one of excessive buildups of private debt and banks’ assets. The result of these excessive buildups of private debt and balance sheets is that the stock deflation processes described in the previous section operate with full force. As a result, the equilibrating mechanism that exists in normal recessions does not function. The lower interest rates engineered by central banks are not transmitted by the banking sector into lower loan rates for consumers and firms. In addition, we now are confronted by the interaction of the flow and stock deflations. This interaction amplifies these deflationary processes. This interaction, which is especially strong in the US, can be described as follows. Because of excessive debt accumulation of the past, households desire to reduce their debt levels. Thus they all attempt to save more. As argued earlier, these attempts are self-defeating. As a result, households fail to save more, and thus fail to reduce their debt. This leads them to increase their attempts to save more. The fact that the banks do not pass on the lower deposit rates into lower loan rates makes things worse. There are no incentives for firms to increase their investments (no dissaving). Nothing stops the deflationary spiral.

The interaction goes further. The deteriorating conditions in the “real economy” feed back on the banking system. Banks’ loan portfolios deteriorate further as a result of increasing default rates. Banks reduce their lending even further, etc. In De Grauwe(2009) it is shown that a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.

The irrelevance of modern macroeconomics

Modern macroeconomics as embodied in Dynamic Stochastic General Equilibrium models (DSGE) is based on the paradigm of the utility maximizing individual agent who understands the full complexity of the world. Since all individuals understand the same “Truth”, modern macroeconomics has taken the view that it suffices to model one “representative individual” to fully represent reality. Thus as a consumer the agent continuously maximizes an intertemporal utility function and is capable of computing the implications of exogenous shocks on his optimal consumption plan, taking full account of what these shocks will do to the plans of the producers. Similarly, producers compute the implications of these shocks on their present and future production plans taking into account how consumers react to these shocks. Thus in such a model coordination failures cannot arise. The representative agent fully internalizes the external effects of all his actions. When shocks occur there can be only one equilibrium to which the system will converge, and agents perfectly understand this (Woodford(2009)).

Deflationary spirals as we have described them in the previous sections cannot occur in the world of the DSGE-models. The latter is a world of stable equilibria. It will not come as a surprise that DSGE-models have not produced useful insight allowing us to understand the nature of the present economic crisis. Yet vast amounts of intellectual energies are still being spent on the further refining of DSGE-models.

Collective action to stop the deflationary spirals

The common characteristic of the different deflationary spirals is a coordination failure. The market fails to coordinate private actions towards an attractive collective outcome. This market failure can in principle be solved by collective action. Such a collective action can only be organized by the government. Let us analyze what this collective action must be to deal with the different forms of deflation.

The key to economic recovery is the stabilization of the banking sector. As argued earlier, a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.

There is no secret about how the bank credit deflation can be stopped. Here are the principles (see Hall and Woodward(2009) for a more detailed analysis). First, bad loans should be separated from good loans, putting the former in separate entities (“bad banks”) to be managed by specialized management teams whose responsibility it is to dispose of these assets. Losses on these bad assets are inevitable, and so is the inevitability that the taxpayer will be asked to foot the bill.

The good loans remain on the balance sheet of the “good bank”. The hope is that this good bank, freed as it is from the toxic assets, will feel liberated and will be willing to take more risk so that the credit flow can start again. One can doubt, however, that a privately run good bank will have sufficient incentives to start lending again. The reason is that extreme risk aversion and a desire to “save the skin” of the shareholders will restrain the managers of the good bank in extending loans. If that is what the managers of the good bank do, the bank credit deflation process described earlier will not stop. This leads to the issue of whether it is not desirable to (temporarily) nationalize the good bank. Such nationalization would take away the paralyzing fear that new bank loans put the bank’s capital (and its shareholders) at risk.

There is a second reason why the government may want to temporarily nationalize the good bank. The bad bank – good bank solution carries the risk of socializing the losses while privatizing the profits. Indeed, the losses of the bad bank will necessarily be borne by the taxpayers. If the good bank remains in private ownership the expected future profits will be handed out to the shareholders. But these profits will be realized only because the toxic assets have been separated and the losses on these assets have been borne by taxpayers. It is therefore more reasonable to make sure that these future profits are given back to the taxpayers.

The resolution of the bank crisis along the lines discussed in the previous paragraphs is a necessary condition for the recovery. It will also make the use of other macroeconomic policies easier and more effective. These other macroeconomic policies must be geared towards resolving the other deflationary processes. Let us discuss these consecutively.

The Keynesian savings paradox

The collective action failure implicit in the Keynesian savings paradox calls for the government to do the opposite of what private agents do, i.e. to dissave. Dissaving by the government is a necessary condition for making it possible for private consumers to succeed in their attempts to save more.

A well-functioning banking sector reduces the need for dissaving by the government. When the banking sector works well, the consumers’ attempts to save more leads to a lower interest rate and induces firms to invest more (they dissave). As a result, the required dissaving by the government is reduced correspondingly.

Fisher’s debt deflation

Government action is required to solve the coordination failure implicit in the debt deflation process. This can be done by taking over private debt and substituting it with government debt. In doing so, the government makes it possible for the private sector to reduce its debt level. The private sector will then stop attempting (unsuccessfully) to reduce its debt level. The debt deflation process can stop.

The issue that arises here is whether the substitution of private by government debt will not lead to unsustainable government debt levels. There are two aspects to this issue. Let us first look at the debt levels of the public and private sectors in the eurozone. These are shown in figure 1. The most remarkable feature of this figure is how low the government debt is relative to private debt. In addition, the government debt is the only one that has declined (as a percent of GDP) during the last 10 years. This contrasts with the debt of households and especially the debt of financial institutions that has increased significantly and that stood at 250% of GDP in 2008. This is three times higher than the debt of the government which stood at approximately 70%. We conclude that more than the public debt, the private sector’s debt has become unsustainable. The process of substitution of private debt by public debt can go on for quite some time before it reaches the levels of unsustainability of the private debt.

Figure 1

Source: European Commission

The second dimension to the sustainability issue of government debt arises from the question of what will happen in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon. As a result, output and income are likely to go down further. This will negatively affect tax revenues and will increase future budget deficits, forcing governments to increase their debt. Refusing to stop the debt deflation dynamics by issuing government debt today will not prevent the government debt from increasing in the future. The same problem of sustainability of the government debt will reappear.

To conclude it is useful to formulate a methodological note. The effectiveness of fiscal policies has been very much analyzed by economists. It appears from the empirical evidence that fiscal policy is limited in its effect to boost the economy. This evidence, however, is typically obtained from equilibrium models estimated during “normal” business cycle movements (see e.g; Wieland(2009), Cogan, et al. (2009)). In the context of the flow and stock deflations that are disequilibrium phenomena and that at the core of the present economic downturn, fiscal policy becomes an instrument to stabilize an economy that otherwise can become unstable. This feature is absent from modern macroeconomic models that are intrinsically stable. The evidence obtained from these models may not be very relevant to gauge the effectiveness of fiscal policies in the present context.

Paul de Grauwe is professor of economics, Catholic University of Leuven.

References

Akerlof, G., and Shiller, R., (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press, 264pp.

Cogan, J, Tobias, C, Taylor, J, and Wieland, V., (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009.

De Grauwe, P. (2009), Keynes’ Savings Paradox, Fisher’s Debt Deflation and the Banking Crisis, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Work_in_progress_Presentations/Flow-Stock%20Deflations.pdf

Fisher, I, (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, 1, October, pp. 337-57.

Hall, R., and Woodward, S., (2009), The right way to create a good bank and a bad bank, www.voxeu.org/index.php

Minsky, H., (1986), Stabilizing an Unstable Economy, McGraw Hill, 395pp.

Wieland, V., (2009), The fiscal stimulus debate: “Bone-headed” and “Neanderthal”? http://www.voxeu.org/index.php?q=node/3373

Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279"

Nice historical, interactive graph of U.S. personal savings as a % of disposable income

From Paul Kedrosky:

"U.S. Savings Over Time, the Interactive Edition

Nice historical, interactive graph of U.S. personal savings as a % of disposable income:

[via iCharts]

Me:

Over 5% would seem to be what Fisher calls 8) Hoarding and slowing down more the velocity of circulation ( P. 342 ), and I call a Savings Spree, based on recent behavior. Of course, the savings rate has been higher in the past, but it doesn't seem to come naturally to us, only as a result of downturns.

"Ad hoc nationalisation of insolvent banks and recapitalisation of impaired ones is simply not enough."

From the FT:

"Saving the banks

Published: January 16 2009 20:00 | Last updated: January 16 2009 20:00

This week, banks ran into yet deeper crisis: the sector is in more trouble than was feared. As Ben Bernanke, chairman of the US Federal Reserve, noted in a speech in London this week, however, economic recovery will not begin until the financial sector recovers its health. Governments must act.( ONLY GOVERNMENTS CAN STOP A CALLING RUN OR PROACTIVITY RUN. )

In October, following a British lead, governments around the world recapitalised their banks. This drastic measure saved the sector from collapse( TRUE. PEOPLE WHO SAY THAT WE SHOULD HAVE LET THE BANKS FAIL ARE WRONG. ) . But, as the events of this week have demonstrated, the banks are still on the ropes.( THE CALLING RUN CONTINUES, NOW WITH A PROACTIVITY RUN AND SAVING SPREE ON ITS HEELS. )

Bank of America required $20bn of capital and guarantees from the US taxpayer and Anglo Irish Bank was nationalised( THE CORRECT MOVE. ) to halt a run by depositors( NOW A POSSIBLE BANKING RUN. WE'D BETTER GET GOING HERE. ). Deutsche Bank, meanwhile, revealed striking fourth-quarter losses. Banks are not lending, but are hoarding capital in readiness to absorb losses from existing bad loans and securities.( THEY'RE TAKING THE MONEY TO USE IN THE ONGOING CALLING RUN. )

Governments must now act swiftly to move ahead of the crisis( LIKE NOW! ). Ad hoc nationalisation( THE PROBLEM. ) of insolvent banks and recapitalisation of impaired ones is simply not enough. Governments must act to draw out the poisonous uncertainty caused by the toxic assets held by solvent banks.

The first option is to create a “bad bank”( A NATIONALIZED BANK OF CRAP ): in this model, the state would buy up toxic securities from a range of banks and hold them. This would force participating banks to declare large losses, but by removing these illiquid assets from the balance sheet, create certainty about their solvency( OR NOT ). It would be a difficult policy to run: it would involve pricing assets that have proved unpriceable( THAT'S BEEN MY POINT SINCE OCTOBER ) and require enormous, up-front costs( YES. HOPING THAT SOMEDAY WE'LL BE ABLE TO SELL SOME OF THIS CRAP. ). The US Treasury’s $700bn troubled asset relief programme was originally intended as a bad bank programme, but changed focus for these reasons.( CATE SAYS BECAUSE THEY BELIEVE THE CRAP OR TOXIC ASSETS ARE AN ALMOST TOTAL LOSS, AND WILL INVOLVE A HUGE LOSS OF TAXPAYER MONEY. )

A better solution, albeit one that must be worked out bank-by-bank, is the insurance model used at Citigroup and, this week, at Bank of America. Governments can, for a fee, issue insurance on the value of a bank’s unpriceable assets, making up the difference if they fall below an agreed floor price( A BETTER PLAN ). Investors would know that the bank is secure – as with the bad bank model – but it reduces the need for already stretched finance ministries to find money immediately. Simply writing the insurance makes it less likely it will even be needed.( THAT'S ALSO THE POINT OF EXPLICIT GOVERNMENT GUARANTEES. IF YOU STOP THE CALLING RUN, THE LOSSES STOP! )

Even after that, however, governments may need to do yet more. They may guarantee credit yet further( COMPLETELY AND EXPLICITLY. ONLY GOVERNMENT HAS THE RESOUCES BEHIND IT TO END A CALLING AND PROACTIVITY RUN. ANY OTHER SOURCE, INCLUDING PRIVATE SOURCES, WON'T WORK. A FEW WILBUR ROSS INVESTMENTS CAN'T STOP A CALLING RUN FOR HEAVEN'S SAKE. ), perhaps even lending directly, in sectors where commercial lenders have all pulled out. Countries that used to rely on credit from abroad that has now disappeared, as is the case in the UK, may still be stretched even if their domestic banks extend themselves fully. Fixing the banks will not cause a return to growth: we are now caught in the jaws of a global recession. It is, however, a necessary precondition for recovery( TRUE )."

Thet only answer is nationalization or explicit guarantees covering all these investments. If we would have stopped the Calling Run ( Debt-Deflation Spiral ) earlier, none of this would have been necessary. Those who say that we couldn't have done this are wrong. Since we're moving inexorably towards Nationalization, I believe that my theory is being proven correct. It certainly explains events better than a lot of so-called experts theories do.

"How will the rest of the world restructure in the face of a United States hell-bent on replenishing its bank accounts?"

Paul Kedrosky on a Savings Spree:

"PAUL KEDROSKY

From Friday's Globe and Mail

January 16, 2009 at 7:23 AM EST

In one of the biggest and most misunderstood changes in modern economic history, citizens of the largest economy in the world are suddenly doing something they haven't done in years: They're saving money. It is having myriad consequences, including a tsunami of money in one part of the world, and an air pocket in demand in other parts of the world, especially China.

Americans are suddenly spending less than they earn. While that might not sound heretical or surprising - how long can you go on spending more money than you earn? - it is an epochal moment for the free-spending United States. After saving an average of more than 7 per cent of disposable income until almost 1990, the United States went into a savings tailspin. Savings rates fell, in fits and starts, from 8 per cent, through 6 per cent in the early 1990s, to 2 per cent around 2000, to the ignominy of a negative savings rate by mid-2005.

Now, however, that is changing rapidly. November economic data showed U.S. savings spiked to 2.8 per cent of disposable income, up from zero at the beginning of 2008. Is it that Americans have suddenly figured out that saving is a good thing, or are they taking some sort of moral stand against profligate spending?

Be serious. Americans remain the wild-eyed spenders of the world, and that was never likely to change without external pressure. They have, however, been forced into this, with their equity investments and real estate investments all sliding into nothingness, and with the economy in a deep recession. They must repair their broken personal balance sheets, and so, as painful as it might be, they are saving money. ( I AGREE )

Great. Good for Americans, right? Savings über alles! Well yes, but there is much more to it than that. For starters, the U.S. savings rate won't stop at 2.8 per cent. My guess is it will rapidly rise to 4 per cent by the end of the year, and will likely hit 7 per cent by late 2010.( I SAY 5% )

But in the end, fixating on those numbers misses everything that matters because that money has to come from somewhere. Your savings, in some sense, represent my lost income. Increased consumer savings is like extending a dam further into a river of money - call it personal income - and diverting some of the flow into a different river. Instead of going into the river called "consumer spending," more of it is going into the river called "savings."( BUT THAT CAN END UP AS INVESTMENT MONEY )

To put it in context, a U.S. savings rate of minus 1 per cent meant roughly $2-million a minute was flowing out of U.S. consumer savings into other things, mostly consumption, like TVs and home renovations, and so on. Or, on an annual basis, that worked out to almost $1.3-trillion exiting the U.S. banking system for other places.

Turn that around, however, and things get very different, very quickly. At a 3-per-cent savings rate, the United States will see $3.8-trillion showing up next year in the banking system just from domestic savers. At 7 per cent, almost $9-trillion will come rushing in as part of the savings tsunami( SPREE ). It is a fire hose of money pointed at the banks, and it's just beginning.

These are ear-popping figures. Three per cent, for example, produces almost five times as much in one-year U.S. capital inflows as the entirety of China's current Treasury holdings. It is four times as much as the proposed Obama stimulus plan. In short, at even relatively small changes, at least in percentage terms, the United States will rapidly transform its banking system and its capital markets.

All that money has to come from somewhere, however, and among the main sources will be the United States' largest trading partners, chief among them China. The U.S. economy is more than three times the size of China, and if you match the U.S. trade deficit against the Chinese trade surplus you'll see that China accounts for, on average, about 60 per cent of the U.S. deficit. As a result, China is going to need to find a way to replace more than 10 per cent of its gross domestic product if the U.S. savings rate returns to its historical norm( THEY REALLY DON'T WANT TO ). Making matters worse is that Chinese consumers are a smaller percentage of GDP than their U.S. counterparts, so to make the math work, Chinese consumers would have to up their buying by something like 25 per cent. Will it happen? No way.( I AGREE )

To be fair, China is not the only country faced with the problem. Similar situations exist in most countries with which the United States has deficits, all of whom are going to see massive export declines as U.S. consumers turn spending into savings. It will be the biggest story of 2009: How will the rest of the world restructure in the face of a United States hell-bent on replenishing its bank accounts( ALLOW US TO DEFAULT OR CONSUME LIKE HELL ) )? In the short run, it can't, which is, in part, why we're seeing the global trade tailspin that we are.

Paul Kedrosky is Senior Fellow at the Kauffman Foundation, and editor of Infectious Greed, a popular financial blog"

Since I see the Savings Spree as a reaction to this crisis, I don't see it lasting. However, I wish it would. We need to save more.