WE KNOW A LOT more about financial conditions than we did a few days ago. First, it is clear that the Fed’s decision to make the discount window more accessible succeeded in calming the financial waters. But no more than that: it has not sufficiently eased the liquidity problem to allow money to flow where it is most needed. That is partly due to the banks’ reluctance to use the window, historically a stopover place for the halt and the lame for whom even a trip to the financial equivalent of Lourdes would provide no cure, and partly due to a reluctance to allow the Fed to put a value on their assets, a value certain to be below that shown on their books.
Second, we know that there are fewer degrees of separation between financial markets and “the real economy” than most experts thought last week, with Larry Lindsey the notable exception. Not that the real economy isn’t relatively healthy: it is. Businesses are still making money, consumers still have jobs, incomes are still rising, and as Jeffrey Lacker, president of the Richmond Fed points out, “the fundamentals for broader household and business spending continue to look fairly sound.” But the seizing up of credit has exacerbated the problems of the housing market, with unsold new and existing homes creating a glut in most markets; layoffs in the financial sector will add at least a bit to the rolls of the unemployed; and there has to be some nervous sweat in the air-conditioned board rooms of America. All in all, the turmoil in financial markets now seems likely to discourage “real” economic activity, but probably only enough to reduce the growth rate in the rest of the year, with a worst case being a modest negative for a short period of time. The world of long-term continued economic growth is not coming to an end.
Third, political pressures on the administration seem to be rising. RealtyTrac Inc reports that foreclosures in July were 9 percent above June levels, and 93 percent above July 2006. Best guess is that before the current shake-out in the subprime market is over, some 1.7 million families will lose their homes.
The administration is eager to avoid what economists and policymakers call the moral hazard associated with a bail-out. But against that danger it has to weigh what economists call the externalities — the effects on innocent bystanders and society at large. Foreclosed homes reduce the value of all homes in a neighborhood, even those owned by families who are up-to-date on their mortgage payments.
So the Democrats are proposing solutions that range from changing the bankruptcy laws to allowing troubled homeowners and their lenders more leeway in negotiation workouts, to increasing the activity of Fannie Mae and Freddie Mac (a client) in mortgage markets, both at the high “jumbo mortgage” (over $417,000) end and at the subprime level (the latter do not now “conform” to the lending standards of Freddie and Fannie). The administration, unhappy with the past accounting practices of these organizations, is resisting. No one can predict how that political battle will play out. But inaction by the administration, no matter how justified, may carry a price at the polls.
Meanwhile, we keep learning more and more about markets dominated by instruments created by mathematicians to be valued by models that do not quite seem up to the task. More important, the Fed keeps learning more and more; it is, after all, the institution that Lacker points out “has tools at its disposal that can help the market make the necessary adjustments.” In the near term, the conclusions the Fed draws from these new lessons will determine the duration and depth of the liquidity portion of the markets’ current problems.
In the longer-term, it is the hard lessons learned by lenders and borrowers that will matter. It was ever thus. On 27 June 1772, David Hume wrote to Adam Smith, commenting on the financial crisis of the day, “…On the whole, I believe, that the Check given to our exorbitant and ill grounded Credit will prove of Advantage in the long run, as it will reduce people to more solid and less sanguine Projects, and at the same time introduce Frugality among the Merchants and Manufacturers: What say you?”
Unfortunately, so far as I can tell, Smith never answered Hume’s question.
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).
