Thu, Oct 30, 2008 - Page 9 News List

Greenspan Folly makes room for a new New Deal

Easy money fueled the credit crisis, and the severity of the outcome will prompt a re-evaluation of the model that informed economic policy in the US for decades

By Jeffrey D. Sachs

This global economic crisis will go down in history as Greenspan’s Folly. This is a crisis made mainly by the US Federal Reserve Board during the period of easy money and financial deregulation from the mid-1990s until today.

This easy-money policy, backed by regulators who failed to regulate, created unprecedented housing and consumer credit bubbles in the US and other countries, notably those that shared the policy orientation of the US. The bubble has now burst, and these economies are heading into a steep recession.

At the core of the crisis was the run-up in housing and stock prices, which were way out of line with historical benchmarks. Greenspan stoked two bubbles — the Internet bubble of 1998-2001 and the subsequent housing bubble that is now bursting. In both cases, increases in asset values led US households to think that they had become vastly wealthier, tempting them into a massive increase in their borrowing and spending — for houses, automobiles and other consumer durables.

Financial markets were eager to lend to these households, in part because the credit markets were deregulated, which served as an invitation to reckless lending. Because of the boom in housing and stock market prices, US household net wealth increased by around US$18 trillion during 1996-2006. The rise in consumption based on this wealth in turn raised house prices further, convincing households and lenders to ratchet up the bubble another notch.

This has all come crashing down. Housing prices peaked in 2006 and equity prices peaked last year. With the collapse of these bubbles, paper wealth of perhaps US$10 trillion, or even as much as US$15 trillion, will be wiped out.

Several complex things are now happening simultaneously. First, households are cutting back sharply on consumption, since they feel — and are — vastly poorer than they were a year ago. Second, several highly leveraged institutions, such as Bear Stearns and Lehman Brothers, have gone bankrupt, causing further losses of wealth (for these failed institutions’ shareholders and creditors) and a further loss of credit that these firms once supplied.

Third, commercial banks also lost heavily in these dealings, wiping out much of their capital. As their capital declines, so, too, do their future loans.

Finally, the failure of Lehman Brothers and the near failure of the insurance giant AIG incited a financial panic in which even healthy firms are unable to obtain short-term bank loans or sell short-term commercial paper.

The challenge for policymakers is to restore enough confidence that companies can again obtain short-term credit to meet their payrolls and finance their inventories. The next challenge will be to push for a restoration of bank capital so that commercial banks can once again lend for longer-term investments.

But these steps, urgent as they are, will not prevent a recession in the US and other countries hit by the crisis. The stock and housing markets are unlikely to recover anytime soon. Households are poorer as a result and will cut back sharply on their spending, making a recession inevitable in the short run.

The US will be hardest hit, but other countries with recent housing and consumption booms (and now busts) — particularly the UK, Ireland, Australia, Canada and Spain — will be hit as well. Iceland, which privatized and deregulated its banks a few years ago, now faces national bankruptcy because its banks will not be able to pay off foreign creditors who lent heavily to them.

This story has been viewed 4198 times.

Comments will be moderated. Keep comments relevant to the article. Remarks containing abusive and obscene language, personal attacks of any kind or promotion will be removed and the user banned. Final decision will be at the discretion of the Taipei Times.

TOP top