By Andrew Smithers

The aim should be to avoid a deep recession or prolonged weak growth, and to avoid a rapid recovery, which would induce a rise in inflationary expectations. This means a year or more of sub-trend growth, i.e. GDP plus or minus 1 per cent per annum. I think we have a good chance of muddling through, but at the moment the risks of inflation are surely much less than the risks of a deep recession. If that occurs the cause will be inadequate credit growth induced by the inadequate equity of banks and also, very importantly, inadequate profit retentions to support balance sheet growth. (As the latest FDIC report shows, US banks had negative retentions in the first half of 2008.)

Banks need more equity, and sufficient retentions to allow them to grow their balance sheets. It is generally believed that the prices of banks’ assets if sold at auction would be “too cheap”. The authorities should require banks to value their assets at these levels and to make conservative reserves against future losses. Banks would then fall into one of three categories: (i) those with adequate capital for regulatory purposes, who would need to take no action (ii) those with inadequate regulatory capital, who would be required to raise new equity and would be capable of raising it from private sources and (iii) those that would need the injection of preferred capital by the government as proposed by Charles Calomiris.

Provided that the prices of bank assets were then truly underpriced and the reserves were truly conservative, banks would experience good profit growth as the assets were repaid and new loans made with higher margins. If this induced too rapid a recovery, the Fed should respond quickly with higher interest rates.

by Charles Calomiris

The US government is considering broad-based assistance to stem the financial crisis. Hank Paulson, Treasury secretary, and Ben Bernanke, Fed chairman, have proposed the establishment of an entity that would purchase subprime-related assets from troubled financial institutions.

A broad-based approach is needed, but this is not the best way of achieving policymakers’ objectives. Government injections of preferred stock into banks, advocated by Senator Charles Schumer, inspired by the Reconstruction Finance Corporation’s policies in the 1930s, would be a better choice. Pricing subprime instruments for purchase would be very challenging, and fraught with potentially unfair and hard-to-defend judgments. If the price were too low, that could hurt selling institutions; if it were too high, that could harm taxpayers. Who would determine how much should be purchased from whom in order to achieve the desired systemic risk reduction consequences at least cost to taxpayers? How would the purchasing entity dispose of its assets?

By Kenneth Rogoff  

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

It is true that the US government has very deep pockets. Privately held US government debt was under $4,400bn at the end of 2007, representing less than 32 per cent of gross domestic product. This is roughly half the debt burden carried by most European countries, and an even smaller fraction of Japan’s debt levels. It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, Wednesday’s $85bn bail-out of the insurance giant AIG.

The remainder of this column can be read here. Discussion from our forum member and contributors appears below.

by Martin Wolf

These are dramatic times. By Monday of this week, three of Wall Street’s top five investment banks – Bear Stearns, Lehman and Merrill Lynch – had disappeared as independent entities. The insurance group AIG is in serious trouble. What was, until recently, the brave new US financial system is melting away before our eyes.

Over the past few weeks three experiences have helped clear my mind on this crisis. First, I reread Hyman Minsky’s masterpiece, Stabilizing an Unstable Economy. Second, I engaged in a debate on the future of regulation with my admired colleague and friend, John Kay.* Finally, on Monday, I moderated a session on this crisis at the Swift International Banking Operations Seminar in Vienna.

I structured this latter discussion around four questions. What went wrong? Is the worst over? What are the lessons for financial institutions? What are the lessons for governments? Here then are my current answers to these questions.

The remainder of this column can be read here. Discussion from our forum members and contributors appears below.

By Martin Wolf 

Creditworthy governments always come to the rescue of large financial institutions, particularly when many are in trouble at the same time. Since institutions do not come bigger than Fannie Mae and Freddie Mac, the rescue announced by the US government over the weekend was a foregone conclusion. That these were “government-sponsored enterprises” made it a certainty. Since these institutions have been financing some three-quarters of US mortgages, the socialisation of the risks of housing finance is also close to complete.

I have little objection to the bail-outs. For reasons laid out in my article earlier this week (“No alternative to nationalisation”), the US government could not let institutions with combined liabilities equal to 40 per cent of US gross domestic product collapse. It can, however, spare us homilies on the sacred role of free financial markets for a long while.

The remainder of this column can be read here. Discussion from our forum members and contributors appears below.

From Willem Buiter’s Maverecon blog

The US Secretary of the Treasury, Hank Paulson, has at last pulled the plug on the two giant GSEs (government sponsored enterprises), Fannie Mae and Freddie Mac.

That it was the big man himself who wielded the knife (or should that be the bazooka?) rather than his sidekick Jim Lockhart, Director of the Federal Housing Finance Agency (FHFA, the regulator of the GSEs), is clear from Paulson’s statement on Sunday, September 7, 2008: “I support the Director’s decision as necessary and appropriate and had advised him that conservatorship was the only form in which I would commit taxpayer money to the GSEs.”

What was decided? Continue reading “Better late than never, or two cheers for Hank Paulson” »

A Republican administration has nationalised Fannie Mae and Freddie Mac, though it is nationalisation with US characteristics. As a result, US housing finance has been brought under direct government control and, in the process, the gross liabilities of the US government, properly measured, have increased by $5,400bn (€3,800bn, £3,000bn), a sum equal to the entire publicly held debt and 40 per cent of gross domestic product.Yet the administration is merely recognising the reality that these “government sponsored enterprises” were undertaking a public purpose, at the public’s risk, though not without dispensing vast rewards to management along the way. That is a scandal. Whether the body politic will recognise it remains unclear. Since this is a bipartisan mess, the likely answer is No.

So what has the administration done? Was there an alternative? Will it work? What lessons should be learned?

The remainder of this article can be read here. Comment from our expert panel appears below.