“Houston, we have a problem”. That innocuous message was how Apollo 13 reported to Mission Control it was in deep trouble, way back in the early 1970s.

This may also after all be the true nature of the US financial and economic condition today. This may have been sensed for some time, at least by some, in academia but also at key central banks groping for answers with extremely limited means, just as in the real Apollo 13 drama. But the full extent of the awfulness has probably escaped many so far.

More drastic action may be required to address what is ailing. Low interest rates, generous liquidity provision, public guarantees safeguarding the continued existence of the US main mortgage guarantors (known as Fanny Mae and Freddie Mac) and the odd tax rebate probably won’t be enough to address the still spreading rot.

Indeed, according to Larry Summers US policymaking has become increasingly reactive and erratic, with a growing tendency to repeat traditional errors.

While US policymakers have long cited Japan’s indecisiveness with respect to troubled financial institutions, its resort to gimmickry and market manipulation, and its lack of transparency in the management of financial crisis in the 1990s as a negative example, they are increasingly repeating Japan’s errors.

One such instance, according to Summers, is guaranteeing the Fannie Mae and Freddie Mac balance sheets without imposing penalties on shareholders or forcing any changes on management.

Dancing at the edge

To put it mildly, Americans have this past year given the impression of dancing on the edge of a financial precipice, with real danger of getting sucked into a wild cauldron from which it would be difficult escaping. The big comparison is with the 1930s and frankly it can’t be said often enough.

But the US isn’t the only party at risk. If they were to go over the edge, others would get sucked along as well in the tumult that would follow.

This is probably one very important reason why South Africa today is running a high interest rate defence (to prevent its currency from being attacked) and why in real terms it probably will keep running one for some time to come. Anything to keep the wolf from the door.

It probably wouldn’t prevent us from being drawn in if the worst were to happen globally, at which point all policy prescriptions would change fundamentally (preferring instead to let the currency take the burden). But it may keep us in the short-term from being prematurely devastated by changing global risk appetite accompanying all this global tumult.

If Barack Obama rather than John McCain becomes the next US President early in 2009, it is most likely that Larry Summers would again be appointed US Secretary of the Treasury, a position he last occupied eight years ago under Clinton.

The views of Larry Summers therefore matter for one simple important reason. The problems would be for him to sort out, assuming a willing Congress.

On the other hand, Senator McCain seems to have closed the poll gap with the frontrunner (depending on who you want to believe). But it is not quite obvious who he would pick as financial point man, were he to clinch the election.

McCain was apparently seriously considering Phil Gramm as his future man at the Treasury. That is, until Gramm suggested the US is merely suffering from a mental recession and is complaining too much. Take an aspirin and sleep it off, whatever is ailing.

That unfortunate remark sidelined Gramm, but it hinted at a lingering perceptual gap between mainline democrats and republicans regarding current problems and possible solutions.

Paulson is a hybrid

Hank Paulson, ex-CEO of Goldman Sachs and the current US Secretary of the Treasury, is a hybrid bridging the Republican/Democrat divide. He favours mainly market solutions but oversaw the public guaranteeing of Fanny and Freddie’s mortgage debt exposure ($5400-billon), which is nationalization by another name, but possibly without enough new oversight (Summers’ beef).

Alan Greenspan, also a Republican, finally acknowledged only very recently that the current US housing, credit and banking crisis is the biggest such financial event in a century. And he expressed deep misgivings about what is being done to Fanny and Freddie, on principled grounds.

According to Greenspan, more regulation isn’t necessarily the answer how to manage better recurring human euphoria and phobias and their resulting excesses, whereas it can interfere with market efficiency.

In contrast, Larry Summers recently spelled out in a Financial Times article how he sees the full depth of what America, and the world, now faces. And what may be needed to escape the clutches of this growing financial US sinkhole.

The prognosis is complicated and dire. The prescription won’t necessarily be generally welcomed, as ever dividing US libertines favouring market solutions from US liberals favouring public intervention.

According to Summers, the main current problems are gradually mounting demand deficiency and bank capital inadequacy. Providing enough liquidity and hoping the markets will arrest and reverse the spreading weakness may not prove to be enough. It may be necessary, but it isn’t sufficient.

Private financial institutions and therefore markets can be overwhelmed. The current confluence of events may well be such an occurrence. More than one commentator of late (Pimco’s co-head Mohamed El-Erian, Harvard’s Kenneth Rogoff, Alan Greenspan himself) has let it be known that one more major US financial institution could still fail (shortly).

As Rogoff put it lyrically last week at a conference in Singapore:

“We are not just going to see mid-sized banks go under in the next few months, we are going to see a whopper, we are going to see a big one, one of the big investment banks or big banks”.

Does one wait until the US economy has retreated to a severely repressed condition before acting supportively?

Summers diagnoses the present US condition as a virulent combination of vicious supply shocks, financial dislocations and concern about rising underlying inflation. And the playout thereof is apparently still intensifying with each passing day.

Four vicious cycles

According to Summers four vicious cycles are under way simultaneously:

· falling asset prices are forcing levered holders to sell, driving prices further down · losses at financial institutions are reducing their ability to finance investment, which in turn reduces asset values, causing further losses
· the weakness of the financial system is reducing growth, which in turn weakens the financial system
· falling output is hitting employment, which in turn leads to reduced demand for output.

The US economy is now operating over two percent below sustainable potential. Growth is likely to remain so slow that the gap between actual and potential output could nearly double over the next year. Output and employment are likely to remain below their potential levels for several years at best. Indeed, concerns about recession are spreading from the US to much of the industrialized world. Significant slowdowns appear more likely in a number of emerging markets.

Much of this weakness can be traced back to the combined impact of rising commodity prices, falling house prices, reduced credit availability and rising uncertainty. Though the US economy has shown some strength in recent months, possibly reflecting enormous resilience, the preponderant probability is that it reflects the support of the tax rebates. As this effect now wears off and tighter credit conditions feed through, the US economy may be expected to take another downwards turn.

In order to short-circuit the spiral of mutually reinforcing financial cycles, Summers favours support of the real economy through temporary fiscal stimulus and of the financial system through measures directed at capital rather than liquidity problems.

With the Fed funds rate already down to two percent, the remaining scope for monetary policy to stimulate the US economy is surely very limited?

As to those wanting to hike interest rates, considering current rates too low and inflation-inducing, one should perhaps remember that the widening credit spreads and increased term premiums have caused borrowing costs to remain very high relative to a Fed funds rate at two percent.

But there remains considerable scope for fiscal policy to stimulate demand on both the tax and spending sides over the next several years.

Given the pressures on state and local budgets and the dramatic cost increases of some inputs, there is now a substantial backlog of US infrastructure projects that have been interrupted or put on hold. Allowing these projects to go forward would stimulate the US economy and channel demand towards construction — the labour segment bearing the brunt of the current economic downturn.

As regards fiscal policy, in the near term larger deficits would be potent in stimulating demand, especially in an economy constrained in its ability to lend and borrow and when new spending is directed at the ‘repressed infrastructure deficit’.

Concrete steps would, of course, also be needed to reduce projected deficits in the medium to long term once the economy returns to full potential.

Similar such efforts should be undertaken globally, in countries where high saving has led to large current account surpluses. This is necessary if the global economy is to be rebalanced without a big downturn as US saving eventually increases. China stands out here.

Points of capital inadequacy

As to the capital inadequacy of the US banking system as it deleverages, Summers offers three points.

Firstly, the US government needs to be able to counter systemic risk when a systemically important institution gets into trouble, yet protecting the interests of taxpayers and the broader financial system. Nothing should be too big to fail. But nothing should be allowed to rupture the system.

Secondly, the large quantity of bad assets on financial institutions balance sheets needs to be addressed. Unlike the operations of the Resolution Trust Corporation in the early 1990s, the US government should establish a mechanism for purchasing assets from stressed banks in return for warrants or other consideration.

Thirdly, will the US government need to find a way to recapitalize institutions through taking some kind of preferred interest, as in the US in the 1930s and in Japan in the 1990s? This is a step one wants to avoid if possible, a very unattractive last resort, but the only remaining copout in the absence of any framework of infusing capital or otherwise simply guaranteeing liabilities de facto or de jure with no other change made, creating problems down the road.

If you hear the politician whispering here, as much in Congress’ ear as in Wall Street’s face, leaving all options on the table, that would probably be a realistic assessment.

Houston, we have a problem. It is most important, a full two years after the US housing market peaked and a full year after the US credit and banking problems burst onto an unsuspecting world, that they keep their act together over there.

Indeed, make haste with yet more comprehensive solutions, for the breaking wave of financial crises and macro-economic backsliding seems to be steadily overtaking the US, and by all appearances also Europe and Japan.

If not arrested speedily, things could get a lot worse, also for emerging markets.

Cees Bruggemans is chief economist of First National Bank.


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