Global Financial Crisis: Governments to the rescue
[PHOTO: US President elect Barack Obama and US President George W. Bush met for two hours yesterday and spoke about the ongoing global financial crisis and US wars in the Middle East. Pool photos by AP.]
by Lyle Gramley
Stanford Group, Policy Research
Financial markets around the globe have taken a dramatic turn for the worse since the middle of September. Credit spreads widened sharply; asset prices became extremely volatile, and stock prices plunged. In the United States, broad measures of equity prices have fallen by one-fourth just since the middle of September.
These developments provoked an aggressive response by governments and central banks around the world in an effort to calm financial markets and prevent the financial crisis from driving the world economy into a profound recession. Equity was injected into banks; guarantees were established for interbank lending, and deposit insurance systems were strengthened. In the United States, deposit insurance was extended to money market mutual funds to stem the tide of outflows. New swap lines were created between the Federal Reserve and some central banks abroad, and existing swap lines were increased to ensure that demands for dollars by financial institutions abroad could be met.
The Fed also took additional steps to provide liquidity to troubled markets. A lending facility was established to provide funds to depository institutions and bank holding companies to acquire asset-backed commercial paper. A money market investor funding facility was created to provide additional liquidity to money market investors. And a commercial paper funding facility was established to provide a liquidity backstop to issuers of commercial paper. This facility was developed in response to a sharp curtailment of the volume of outstanding commercial paper, as some issuers were completely unable to roll over maturing issues, and others could roll over maturing obligations only on an over-night basis. This facility permits the Fed to acquire commercial paper of nonfinancial as well as financial firms, thus effectively meeting the short-term credit problems of large, well-established, business firms.
There is some evidence that these aggressive measures are bearing fruit. The 3-month London Interbank Offer Rate (LIBOR) has declined from a peak of nearly 5% to less than 3%. The 3-month Eurodollar rate has also fallen sharply. Credit spreads on longer-term obligations, however, remain exceptionally high. For example, the spread between corporate Baa issues and 10-year Treasuries is currently about 5-1/2 percentage points, compared with the spread of about 1-1/2 percentage points that prevailed in June 2007, before the credit crisis began.
High interest rates discourage borrowing and spending by both consumers and investors, and tighter lending standards are preventing some businesses and consumers from obtaining the funds they need for financing inventories, purchasing autos, or other purposes. Data from the Federal Reserve's flow of funds accounts indicate that the flow of credit to households and nonfinancial businesses declined by about two-thirds from the third quarter of 2007 to the second quarter of 2008. There is not much doubt that it is has shrunk further since the middle of this year; it is difficult, however, to put quantitative dimensions on that shrinkage. Weekly data from commercial banks indicate that total bank loans have continued to increase, and that all major components “commercial and industrial loans, loans to consumers, and residential real estate loans“ are rising. Nonetheless, dysfunctional credit markets and the severe decline in equity prices are clearly taking an increasing toll on the performance of the real economy.
Consumer spending has been hit particularly hard; adjusted for inflation, personal consumption expenditures fell from June through September. Auto sales in October, moreover, dropped sharply to the lowest annual rate since the recession of 1981-82. The huge decline in oil prices will help to bolster consumer buying power, but its impact is being more than offset at the moment by declining employment, a dramatic loss of net worth, curtailments in credit availability, and a plunge in consumer confidence to recession lows. In constant dollars, consumer spending fell by 3% at an annual rate in the third quarter and will likely fall by a similar amount, if not more, in the current quarter.
Business spending for fixed investment contracted moderately in the third quarter, but larger declines lie just ahead. A well-established empirical principle is the relation between consumer spending and cap ex when consumers retract their purchases, declines in cap ex soon follow. Curtailment in business capital spending will increase downward pressures in manufacturing, which is already feeling the impact of reductions in inventory investment and a weakening of demand for exports. Exports have been a major source of strength to the U.S. economy during the past 2-1/2 years, but the impact of the global recession and the recent rise in the international value of the dollar will both take their toll on shipments overseas.
The housing industry, the first to fall into recession, continues to contract, but at a less rapid pace as one would expect, since housing starts have already declined by two-thirds. A turnaround in housing may be some time off, however, since inventories of unsold homes are still huge and home prices are still declining.
Employment data for October leave little doubt that the economy is contracting sharply. Payroll employment fell by 240 thousand; job levels for August and September were revised down substantially, and the unemployment rate jumped to 6.5% from 6.1% the previous month.
It appears that real GDP will decline in the fourth quarter at about a 3-1/2 to 4% annual rate, the steepest decline since the first quarter of 1982.
The mood of the nation is gloomy, indeed, and understandably so. The current worldwide financial crisis is by far the most serious of the postwar period. The decline in spreads between the 3-month Libor rate and Treasury securities of comparable maturity may be an early sign that credit markets are beginning to thaw. But as Winston Churchill famously remarked following the Allied victory in North Africa in 1942, this is not the beginning of the end, but it may be at the end of the beginning.
A serious recession is now underway, and will probably last until next spring. The current forecast anticipates an end of the recession at, or before, the middle of next year. But that depends critically on the assumption that credit markets will gradually begin to heal. Given the aggressive efforts by the federal government and the Federal Reserve to help restore more normal functioning of credit markets and an indicated willingness to do more if necessary that assumption seems reasonable. Still, there are no guarantees.
Further measures to shore up financial markets and the economy will be needed. Another stimulus package seems a near certainty. A further reduction in the federal funds rate, to ˝%, at the Fed's next policy meeting on December 16 also seems probable. The most important steps taken by the Fed over the past year and more, however, are those that have provided liquidity in massive amounts to meet the unprecedented flight to quality that has been at the heart of the financial crisis.
For a time, the Fed was offsetting the impact of additional loans on the size of its balance sheet by selling Treasury securities. That phase of the Fed's operations as lender of last resort has now ended, and the Fed's balance sheet is growing dramatically. On Wednesday, October 29, 2008, total Reserve Bank Credit amounted to $1,953 billion, up from $869 billion a year earlier. Bank reserves held at the Fed are now rising rapidly, and that will eventually lead to a marked increase in the money stock. Worries are beginning to develop, therefore, that the seeds of a future inflation problem are being sown.
For the next year or more, inflation will go down, not up. Sharply declining prices of oil and other basic commodities are one reason; a global recession of significant dimensions is another. But does not an enlarged money stock provide inflationary tinder that might ignite at some time down the road?
The Fed may have a money management problem to deal with when the credit crisis comes to an end and the economy gets back on its feet again. The huge increase in loans on the Fed's balance sheet that are the source of the increase in bank reserves and the money stock are, however, all short-term; all the Fed has to do is refuse to renew them and the Fed's balance sheet will shrink again. It may take some adroit maneuvering by the Fed to manage down the size if its balance sheet. But problems of that kind are a small price to pay for actions needed to keep the economy from tipping over the edge of the precipice into the abyss.
