The depression of 2009


This was always a tough crisis to handle, but if we had responded to it in an appropriate and forceful manner, the worst could have been avoided. The problem is that we are making all sorts of policy mistakes now, very seriously mistakes. Unless reversed with a weeks at the latest, they will lead to a situation that truly deserves the epitaph of a global meltdown. We would no longer be talking about the worst financial crisis since 1929. It would simply be the worst financial crisis.


Everybody knows the mistakes of the banks, the regulators, or the rating agencies. Now governments on both sides of the Atlantic are committing perhaps even bigger mistakes. It seems that even in times of severe crisis, their main priorities are about short term political gain. The US administrationís TARP proposal is a case in point. It has lambasted by almost every economist, including those who normally disagree with each other on most things. Buying up toxic securities at above market prices is simultaneously the most expensive and unfairest way to recapitalise the banking system. It is very difficult to believe that the US treasury secretary can possibly be driven by a motive other than a wish to benefit the investment banks he once chaired, and which stands gain handsomely from such a package, and which would never dream of accepting any government capital infusions. The only alternative explanation for his behaviour is immense stupidity Ė and I know that he is not a stupid man.


Over here in Europe, the policy response is just as bad. The Germans have been bailing out institutions such as IKB Bank with no systemic relevance whatsoever. The same actually goes for Hypo Real Estate. Its policy relevance is purely to secure Germanyís leadership in the market for Pfandbriefe or covered bonds. In other words, the Germans are bailing out to secure or maintain a competitive edge against other euro area countries. Thatís also behind the Irish rescue programme. Ever the good Europeans, the Irish only care about Dublinís status as a European finance centre. We should not be surprised that Germany stubbornly rejects the idea of euro area wide, or EU wide, bailout scheme. Such a scheme would certainly have to be much better managed. It would be symmetric, perhaps even model-based, as it was the case during the Swedish financial crisis in the early 1990s. The Germans fear that they would lose out, as the EU would almost certainly not rescue the rotten Landesbanken, or other institutions through which the political establishment exercise undue influence.


Financial crises do not automatically produce recessions or depressions. Only bad policy cab turn a crisis into a catastrophe. The 1930 Great Depression could have been avoided if governments had not pursued pro-cyclical policies, and most important, if central banks had not allowed deflation.  We have learned from those mistakes, but are committing new and possibly bigger ones. Government is our one and only safety net. It could, if it wanted to, provide basic financial services, that could easily fulfil three economic functions that are attributed to finance: to provide liquidity, to share risk, and to allow agents in the economy to make inter-temporal choices. You donít need CDOs and CDSs for that. A network of central bank branch offices, in combinations with a relatively small number of national, or nationalised banks, could temporarily offer the vast bulk of all financial service of wider economic relevance. The way to go is to shrink the financial system and nationalise the systemically important financial institutions. I have heard there are about 45-50 in the euro area though this is not a precise guess, and subject to change over time. After the financial sector is stabilised, it is time to rebuilt the system, to allow the government later re-privatise its assets, ideally subject to different incentive structures than those that have led to this crisis. In theory, governments could even make money on it. I doubt it. But at the very least, governments can minimise losses.


But if you squander valuable resources on second-rate institutions such as Hypo Real Estate, for the wrong reasons, your freedom of manoeuvre will be constrained at the moment you need it the most, for example, if or when the German government was called upon to save Deutsche Bank, Allianz, and a couple of Landesbanken on the same day Ė probably a Sunday. The reason why we need a European, and perhaps even a global plan, is that this is the only way to do this if things get really serious.  This is also why investors should completely disregard promises by government to offer infinite deposit insurance. If the German banking system were to collapse, the German government would have to issue bonds to pay for half a trillion euros of deposits, Germany would not be in a position to do so. Its sovereign rating would converge towards the equity tranche of a subprime CDO.


The whole gist of the German governmentís policy consists of a bet that the wider public remains infinitely stupid and ignorant. This bet it will lose.


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