Last Stand At The Alamo

When Paul Krugman sounds like Nouriel Roubini, you know the fecal matter has impacted the oscillator here on a day where the Dow is down 500 at 3 PM or so.

Last month, when the U.S. Treasury Department allowed Lehman Brothers to fail, I wrote that Henry Paulson, the Treasury secretary, was playing financial Russian roulette. Sure enough, there was a bullet in that chamber: Lehman’s failure caused the world financial crisis, already severe, to get much, much worse.

The consequences of Lehman’s fall were apparent within days, yet key policy players have largely wasted the past four weeks. Now they’ve reached a moment of truth: They’d better do something soon — in fact, they’d better announce a coordinated rescue plan this weekend — or the world economy may well experience its worst slump since the Great Depression.

Let’s talk about where we are right now.

The current crisis started with a burst housing bubble, which led to widespread mortgage defaults, and hence to large losses at many financial institutions. That initial shock was compounded by secondary effects, as lack of capital forced banks to pull back, leading to further declines in the prices of assets, leading to more losses, and so on — a vicious circle of “deleveraging.” Pervasive loss of trust in banks, including on the part of other banks, reinforced the vicious circle.

The downward spiral accelerated post-Lehman. Money markets, already troubled, effectively shut down — one line currently making the rounds is that the only things anyone wants to buy right now are Treasury bills and bottled water.

The response to this downward spiral on the part of the world’s two great monetary powers — the United States, on one side, and the 15 nations that use the euro, on the other — has been woefully inadequate.

Roubini too is talking about a laundry list of action that must come from this weekend's meeting or the game is over.

At this point severe damage is done and one cannot rule out a systemic collapse and a global depression. It will take a significant change in leadership of economic policy and very radical, coordinated policy actions among all advanced and emerging market economies to avoid this economic and financial disaster. Urgent and immediate necessary actions that need to be done globally (with some variants across countries depending on the severity of the problem and the overall resources available to the sovereigns) include:

- another rapid round of policy rate cuts of the order of at least 150 basis points on average globally;

- a temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made;

- a rapid reduction of the debt burden of insolvent households preceded by a temporary freeze on all foreclosures;

- massive and unlimited provision of liquidity to solvent financial institutions;

- public provision of credit to the solvent parts of the corporate sector to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses;

- a massive direct government fiscal stimulus packages that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower income households and provision of grants to strapped and crunched state and local government;

- a rapid resolution of the banking problems via triage, public recapitalization of financial institutions and reduction of the debt burden of distressed households and borrowers;

- an agreement between lender and creditor countries running current account surpluses and borrowing and debtor countries running current account deficits to maintain an orderly financing of deficits and a recycling of the surpluses of creditors to avoid a disorderly adjustment of such imbalances.

At this point anything short of these radical and coordinated actions may lead to a market crash, a global systemic financial meltdown and to a global depression. At this stage central banks that are usually supposed to be the "lenders of last resort" need to become the "lenders of first and only resort" as, under conditions of panic and total loss of confidence, no one in the private sector is lending to anyone else since counterparty risk is extreme. And fiscal authorities that usually are spenders and insurers of last resort need to temporarily become the spenders and insurers of first resort. The fiscal costs of these actions will be large but the economic and fiscal costs of inaction would be of a much larger and severe magnitude. Thus, the time to act is now as all the policy officials of the world are meeting this weekend in Washington at the IMF and World Bank annual meetings.

Basically what Krugman and Roubini are talking about here is a Global New Deal. Anything short of that will lead to a multi-year global depression.

Barack Obama at least seems to understand what is at stake judging from his speech today in Ohio.

We meet at a moment of great uncertainty for America. In recent weeks, we've seen a growing financial crisis that's threatening not only banks and businesses, but your economic security, as well. It's getting harder and harder to get a loan for that new car or that startup-business or that college you've dreamed of attending. And yesterday, millions of Americans lost more of their investments and hard-earned retirement savings as the stock market took another significant plunge.

We need action now. The Treasury Department must move as quickly as possible to implement the rescue plan that passed Congress so we can ease this credit crisis that's preventing businesses and consumers from getting loans. And we also must recognize that this is not just an American problem. In this global economy, financial markets have no boundaries. So the current crisis demands a global response. This weekend, finance ministers from the world's major economies will meet in Washington. They must take coordinated steps to restore confidence and to maintain our financial markets and institutions.

It's frightening. But I do not see any other way around this crisis...and the most disturbing part of all is that Bush and Cheney are still in charge, not Obama, for another three months plus. It's three months we don't have...we may not survive the month without immense political will, determination, focus, and more than a bit of luck.

Good luck to us all. We will need it.