- The Washington Times - Wednesday, March 12, 2008


The presidential campaign currently underway has so far missed the historically rare opportunity to engage the candidates in a serious discussion of how they would respond to a very likely impending recession brought on by twin banking and currency crises.

Usually financial crises — and the recessions that often follow — appear without much warning. But today, while of course the future can never be predicted with certainty, the evidence is accumulating to suggest that the United States may soon be facing something similar to Japan’s experience in the late 1980s and 1990s.

As described by Allen and Gale in their 2007 paper “Introduction to Financial Crises,” Japan experienced an expansion of credit following financial liberalization which led to real-estate and stock-market price bubble in the late 1980s — followed by a collapse. “The next few years were marked by defaults and retrenchments in the financial systems. The real economy was adversely affected in the aftermath of the bubble and growth rates during the 1990’s were barely positive or negative.” “Banks and other financial companies that held the stocks and real estate (or [had] made loans on those assets) often came under server pressure from withdrawals because their liabilities [were] fixed and falling prices reduced the value of the assets. Banks in this situation [were] forced to call in loans and liquidate assets, which in turn exacerbate• the problem of falling asset prices.”

Sound familiar? But if anything, we are even more dangerously situated. As Paul Krugman has argued in recent columns (ignore his political rhetoric, but his economic analysis can sometimes be persuasive and chilling): Financial contagion increases the magnitude of the danger. “Troubles that began a little over a year ago in an obscure corner of the financial system, BBB-minus subprime-mortgage-backed securities, have spread to corporate bonds, auto loans, credit cards, and now — the latest casualty — student loans.” Current informed commentaries throughout the financial world are loaded with warnings. J.P. Morgan last week “described what’s happening as a systematic margin call, in which the whole financial system is facing demands to come up with cash it doesn’t have.” We are also experiencing a historic reduction in the value of the dollar. When a banking crisis and a currency crisis occur at the same time, as they are now, they are likely to be followed by a recession — and the recession is likely to be longer and deeper.

And, unlike the Japanese crisis of the 1990s, America’s dominant place in the world economy increases the likely worldwide effect of our crisis and recession. For example, the subprime house mortgage crisis has already been exported to the world because the world has bought those assets, but it never bought much Japanese real-estate mortgage assets in the ‘80s and ‘90s. Further adding to the high risk of economic contraction, of course, is the sharp and continuing rise in oil prices.

Of course, we may get lucky. Perhaps the financial institutions will weather the current storm. Perhaps the dollar will bottom out soon. Perhaps the economy will slow down, but not contract. But so far the Fed’s repeated interventions have not solved the lack of liquidity. So far the markets around the world are betting against good news. And there is talk that the massive Fannie Mae and Freddie Mac real-estate corporations may have liquidity problems.

So, with all this warning, we should expect the presidential candidates to explain — in detail — how they would deal with this crisis. After all, in 10 months one of them, either John McCain, Barack Obama, or Hillary Clinton will be president and quite likely facing one of the worst financial and economic conditions of recent decades. Instead, we get yet more discussion on who is for hope, who has experience, and who is better able to answer the phone at 3 A.M.

Why not have a novel three-way debate on one of the networks for two hours, and see what the three great minds who would be president have to say about what they would do if the likely turns out to happen. I don’t have an answer, but I have the first question for them.

Since World War I, economic historians divide the world’s financial history into three parts: 1) interwar (1919-39); 2) the Bretton Woods Period (1945-71); and the recent period (since 1973). In reaction to the Great Depression of the interwar period, Bretton Woods provided strict regulations of financial institutions. As a result there were few financial crises. Then we liberalized and deregulated in the recent period, and have had several deep crises.

Questions for the candidates: In 2009, should we re-regulate or not? And should we try to ease the pain of the crisis if it comes, or let natural economic forces clear out the dry rot and find the natural bottom? No points for slogans. There will be extra credit for honest thoughtful responses.

Or we continue with Mr. Obama’s people suggesting Mrs. Clinton is a monster, and her people suggesting Mr. Obama is a Muslim (and that Mr. McCain is off the margin somewhere).



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