Financial Crisis 101 - 10/27/08

November 12, 2008 2:37:51 PM PST
It looked like we were headed for a pretty even close in the stock market today until the Dow Jones average plummeted 200 points in the last couple of minutes. Recession fears have a tendency to strike just before the closing bell. There was some unexpected good news today from the Commerce Department. New home sales rose in September by 2.7%. The government expected that number to fall. The price of new homes has apparently fallen so far, 9.1% from a year ago, that there is some buying interest out there. So the hike in new home sales is a mixed blessing. And let's not get intoxicated by the slight boost. The sale of new single family homes last month was still down 33.1% from a year ago.

I admit it's hard to focus on the financial crisis with the Phillies waiting to claim their first World Series title in 28 years. And as every Philadelphia sports fan knows, a win tonight will end the city's quarter- century drought of major sports team championships since the Sixers won in 1983.

But doesn't it seem almost that long since the financial markets behaved nicely and the idea of peeking at your 401k monthly statement didn't bring on a panic attack? Maybe this is why sports hold such a valued place in our society. It offers the whole range of emotions from triumph to defeat, pride to humiliation, from hope to despair and from joy to agony. But while we all identify so closely with our teams, especially around here, we're not responsible for their success or failure.

When real-life calamities strike, like the economic crisis, we have to manage the consequences such as how they impact on our families. However, when the PhilliesEaglesSixersFlyers lose and break out hearts, we can wipe our tears, blame them for messing up again, and then go on with our sports cursed lives. And when you win, then all the other problems seem to fade for awhile, and we can puff out our chests and say "to hell with the economy," if only for a few moments. Well, Philadelphia, and in this case, that includes everywhere from Trenton to Dover, and Atlantic City to Lancaster, get ready for one huge reality-obscuring endorphin rush, cause the Fightin's are gonna wrap this thing up tonight.

So, back to business, literally. Last week, the focus here was on corporate earnings, and there are still hundreds more companies to report. But this week, the Fed will once again claim the spotlight.

Today, the central bank will begin buying the promissory notes of the country's most highly rated companies. A promissory note is like an IOU. If you've heard the term, commercial paper, this is it. Companies use the money from these IOU's to meet operating expenses like payroll. The hope is that with the Fed becoming a lender of first resort, cash poor businesses will be back in the money, and we'll see the credit freeze begin to thaw.

The Fed will be attracting attention for another, more visible reason this week. It will meet tomorrow to decide whether to cut interest rates again. We're talking about the Fed Funds Rate, which is what banks charge for overnight lending to other banks. The rate is already an incredibly low 1.5%, but the Fed could knock off another .5%. Basically, the Fed wants to make it impossible for the banks not to lend each other money. We'll see if the Fed does cut interest rates again, and if it does, we'll see if it works.

There seems to be broad consensus that many of the mechanisms put into effect by the government have begun to loosen up the credit strings. The 3-month Libor moderated a bit today, as did the VIX "fear index." If you've been reading this blog, you know what both of those devices are. If you haven't, you can link back to the explanations.

But just two paragraphs from a Reuter's story today indicated how the financial crisis has become a global calamity. "More U.S. banks lined up for government cash and the Group of Seven expressed concern the soaring Japanese yen posed a threat to financial and economic stability as recession worries spread worldwide.

Countries in Europe and Asia took emergency actions to shore up their financial positions. South Korea cut interest rates, Australia intervened in the currency market, and the International Monetary Fund moved to help Hungary and Ukraine."

That is why today's announcement of a summit meeting on November 15th will be so important. The heads of state of the G-20 countries will come together to discuss the need to rewrite the rules of the global financial system.

Morris Goldstein is a Senior Fellow at the Peterson Institute for International Economics, which is a private, non-partisan research institution. He has proposed what he calls a 10-step recovery program for the world economy. Here it is.

What then to do? The G-20 leaders should pursue the following ten step recovery program:

1. Their central banks should undertake a further coordinated cut in interest rates of 50-100 basis points in all G-20 countries where growth and inflation concerns permit it.

2. Fiscal policy expansion of 1-2 percent of GDP should be implemented in all G-20 countries where such a temporary stimulus would not generate adverse currency and external financing pressures.

3. All G-20 members should continue to monitor closely the capital adequacy and lending behavior of their systemically-important financial institutions and be prepared to intervene forcefully?with appropriate protections for taxpayers?if the flow of credit to the nonfinancial sector is seriously disrupted.

4. The large industrial countries should establish or increase swap lines to the emerging economies that need reserve-currency liquidity, while the emerging economies should refrain (until the crisis is over) from any large-scale shifts in their management of international reserves.

5. The IMF should revive its compensatory finance facility and contingency finance facility to provide quick-disbursing loans to emerging and developing countries with acute but temporary balance of payments problems. Use of these facilities should be linked either to a temporary fall in export earnings (that is largely beyond their control) or to an abrupt fall in private capital inflows (that is not a result of underlying policy inadequacies).

6. The World Bank should redouble its efforts to cushion the effects of this crisis on the most vulnerable, while also holding G-7 members to their Gleneagles commitment of 2005 to increase development assistance.

7. Reserve-currency members of the G-20 should agree to cooperate closely, including the possibility of coordinated intervention, in cases of disorderly exchange markets.

8. G-20 members should commit themselves to refraining from any protectionist trade measures and should agree to consult with other ministers before introducing further public-sector guarantees that could have unfavorable competitive effects on the financial firms of other countries.

9. Any G-20 members who operate or are establishing sovereign wealth funds should agree to abide by the Santiago Principles governing investment standards that were recently agreed for such funds.

10. In G-20 economies where housing prices threaten to overshoot their equilibrium on the down side, and where home foreclosures rates are at historic highs, the authorities should step up actions to reduce foreclosure rates.

But Goldstein is concerned that the G-20 Summit ends up being more grandstanding than purposeful pursuit of worldwide economic recovery. We'll see.

And for those of few who feel more than a little frustrated by the notion that we're in economic crisis mode while the oil-rich kingdoms of the Middle East can't figure out what to do with all their oil money, the Persian Gulf saw its first big bank bailout over the weekend. The Kuwait Central Bank put together a bailout package for one of the country's biggest banks. Suddenly, the economies of the Persian Gulf countries seem vulnerable, the result of a 50% plunge in oil prices. Saudi Arabia is planning government intervention as well and the United Arab Emirates have promised to guarantee domestic bank accounts for three years and back up interbank lending. The Kuwaiti Oil Minister may be singing, "Don't Cry For Me Abu Dhabi," but the fact is, the global financial/economic crisis is creeping into oil-rich nations of the Persian Gulf.

Jim Gardner


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