Nouriel Roubini 10.09.08, 12:01 AM ET
Last week, I suggested the need for a coordinated monetary policy rate cut. That cut arrived yesterday, with the Fed, the European Central Bank and other central banks cutting their policy rates by 50 basis points (bps).
This action is necessary, but only cosmetic, and it is too little too late. European central banks should have cut rates many months ago, before the recession and financial crisis became so virulent. Now, 50bps for the Eurozone is peanuts at a time when a minimum of 150bps is necessary to restart the economy and unclog frozen financial markets; 50bps is also too little in the U.S., given the damage to the real economy of the financial shocks of the last month. During the last recession, the Fed cut the Fed Funds down to 1%; we are still 50bps away from that level. But at the end of this cycle--as I have argued before--the Fed Funds will be closer to 0% than to 1%.
Policy rate cuts will have a limited effect as they don't resolve the fundamental problem in markets--massive counter-party risk--that is keeping money-market spreads relative to safe rates so high. Yesterday's plan to support the commercial paper market is a step in the right direction, but other, more radical policy actions are also needed now. Here are four suggestions for such additional policy action.
--To reduce the counter-party risk in the money markets, a triage between insolvent banks that need to be shut down and a recapitalization of solvent banks is necessary, together with massive injections of liquidity in non-banks and the corporate sector. Direct lending by the government to small businesses--via the Small Business Administration--is also necessary to avoid the implosion of smaller businesses.
--A generalized temporary blanket guarantee of all deposits is now necessary, both in the U.S. and in Europe, followed by a triage between insolvent banks to be closed rapidly and illiquid-but-solvent banks that deserve to be rescued to avoid the moral hazard of such blanket guarantee.
--The flawed $700 billion Troubled Asset Relief Program (TARP) legislation will have to be modified in three ways to: a) allow for direct government injection of public capital in banks in the form of preferred shares, matched by private capital contributions by current shareholders (via suspension of all dividend payments and matching Tier 1 capital provided by private shareholders); b) implement a clear plan to reduce the face value of mortgages for distressed homeowners and avoid a tsunami of foreclosures; c) do a rapid and radical triage between solvent banks and insolvent banks that need to be rapidly closed.
--Given the collapse of private aggregate demand--consumption, residential investment and non-residential investment in structures are falling, and capital expenditure by the corporate sector was falling already before the latest financial and confidence shock and will now be plunging at an even faster rate. You need to give a boost to aggregate demand to ensure that an unavoidable two-year recession does not become a decade-long stagnation.
Since the private sector is not spending, and since the first fiscal stimulus plan (tax rebates for households and tax incentives to firms) failed miserably as households and firms are saving rather than spending and investing, it is necessary now to boost public consumption of goods and services via a massive spending program (a $300 billion fiscal stimulus).
The federal government should have a plan to immediately spend on infrastructure and new green technologies; also unemployment benefits should be sharply increased, together with targeted tax rebates only for lower income households at risk; and federal block grants should be given to state and local government to boost their infrastructure spending (roads, sewer systems, etc.).
If the private sector does not spend and/or cannot spend, old-fashioned traditional Keynesian spending by the government is necessary. It is true that we already have large and growing budget deficits; but $300 billion of public works is more effective and productive than spending $700 billion to buy toxic assets.
So we are now very close to the systemic financial meltdown that I outlined in a paper I wrote in February. But radical action can--and should--be taken to control the damage and prevent this meltdown from occurring.
At this point, the U.S., the advanced economies (and now most likely even some emerging market economies) will experience an ugly recession and an ugly financial and banking crisis--regardless of what we do from now on. We are already now in a global recession that is getting worse by the day. What radical policy action can only do is to prevent what will now be an ugly and nasty two-year recession and financial crisis from turning into a decade-long economic depression.
The financial and economic conditions are extreme; thus extreme policy action is needed now to save the global economy from that very ugly prospect.