Finding the Mess Behind the Mess - The New York Times

Summary:
According to Tyler Cowen, the US is unlikely to experience a lost decade as Japan did in the 1990s, but there will still be a long and protracted process of recovery. Number of problems in the real economy are underlying the financial crisis, and will remain once the financial crisis clears up. Problems faced by the US economy: lack of personal savings (people have for years treated rising asset prices as substitute for personal saving); credit crisis stopping banks from investing our savings and making loans; lower consumer spending, need to produce for export; still excess of homes in the market; energy prices. Further fiscal stimulus and excessive banking regulation will make things worse. Solving these problems will be like untangling a bunch wires: need to carefully pull the right wires, in the right sequence. (Published: 23/08/08)

Notes:

• Japanese recession in 1990s
• set off by bursting real estate bubble
• took economy more than a decade to resume steady, noticeable growth
• unlikely to happen in the US
• but will still see protracted process of recovery
  
• may take longer than the usually year or two to climb out of recession
• usually a crisis in the real economy behind every financial crisis
• based in some underlying structural deficiency
• even if financial crisis is bottoming out, sooner or later the real crisis must be faced
• problems in the US economy
  
• fundamental problem in the US economy:
• for years people treated rising asset prices as a substitute for personal savings
• as long as your home's value rose every year, you didn't have to set aside so much from your paycheck
• if your stocks went up, so much the better
• asset prices haven't been rising much lately
• many people will need more savings for their retirement or possible emergencies
• second problem
• US economy enduring a credit crisis
• many banks trying to raise more capital and make fewer loans
• savings are good for the economy when they lead to investment, but there is no guarantee that financial institutions will be allocating capital efficiently
• third problem
• lower consumer spending
  
• will require the US economy to make some shifts
• may mean fewer Starbucks and fewer new homes, but more tractor production for export to foreign markets
• shifting some consumption to investment probably beneficial to the economy in the long run
• in the short term, may mean job losses and costly readjustments
• fourth problem
• still excess homes on the market
• housing prices need to fall further
• such price declines make banks less solvent and thus worsen the credit crisis
• politicians would like to moderate this fall in prices, prolonging the adjustment process
• fifth problem
• energy prices
• high prices will encourage conservation and cleaner energy alternatives
• but: voters want low gasoline prices and winter heating bills
• politicians see lower energy prices as a way to help the economy in the short run, and as a way to win votes
• evolution of energy prices may not follow any kind of desirable logic
• danger that the Fed will view high energy prices as a sign of permanent inflation and tighten the money supply growth prematurely

• what should policy makers do?
• counterproductive path: further fiscal stimulus in form of tax rebates
  
• can raise consumer spending and bolster economy in the short run
• works only by pushing consumers to spend rather than to save
• merely postpones the needed adjustments by providing a grab bag of goodies at exactly the wrong time
• another danger: excessive bank regulation
• regulatory structure for financial institutions has failed in the current crisis,
• change is in order
• but shouldn't reform in a way that will discourage bank lending and weaken the tie between savings and investment
• banks already allergic to very risky mortgages
• we shouldn't overreact by punishing them for past mistakes
• regulatory reform needs to be forward-looking rather than focused on penance
  
• recipe for success likely requires, in ht right combinations and in the right sequences
  
• smooth adjustment into new growth sectors
• more savings from disposable income
• cleaning up the housing mess
• well-functioning energy markets
• more effective financial intermediation
• but: neither the government or the Fed can control this process
• Fed can add regulatory and monetary clarity, but there isn't any magical bullet

• Japanese failed to break out of their recession quickly because they didn't promptly close down or clean up their bank problems
• so far, Fed and other regulators show no signs of making this mistake
• but: not enough to guarantee a successful transition
• American economy will be tested for its deftness
• test will be difficult because there isn't a single enemy to focus on
• undoing a bunch of tangled wires
• if you don't pull on the right wires in the right order, the mess becomes worse
• if you pull too hard, the whole thing can break
• but if your first pulls are good ones, the untangling becomes easier with each move
• like our economy's situation today
• if we expect too much too quickly, we'll make matters worse
• but: there's a way out of the mess, and it lies in our hands