Saturday, April 18, 2009

No Soft Landing

When the economy is in turmoil, people tend to look for a soft landing, a way to minimize the impact of the changes going on. That’s why Congress and the U.S. Treasury spent a trillion dollars to keep Wall Street from falling apart last fall, for example. Yet the instinct to look for a soft landing can create unnecessary risks for the economy as a whole. I opposed the Wall Street bailout not because Wall Street is not important, but because the costs were so high that the bailout had a destabilizing effect on the economy as a whole, exposing the whole country to risks that, with a different approach, could have been contained.

The risks are becoming easier to see as the economic decline accelerates. After blowing two trillion dollars on two questionable initiatives, it will probably be impossible for the U.S. government to undertake a third. It should instead retain its little remaining borrowing power for an actual emergency. And that is not just my opinion. There is a consensus among economists and financiers that government borrowing has its limits, so it is just a question of where the limits are. Some think we passed them a year or two ago. But the International Monetary Fund (IMF) puts the limits right about where we are now.

The head of the IMF is recommending (from a Telegraph story)

further fiscal stimulus beyond the 2pc of global GDP already agreed. The snag is that high-debt countries may have hit the limits already.

“The impact becomes negative for debt levels that exceed 60pc of GDP,” said the Fund.

According to this model, it is time for the United States to put the brakes on government spending before debt load begins to weigh down the economy. And the IMF is not taking into account the possibility that recent global financial changes could make government borrowing more difficult than in the past. That’s a change that could pull the limits to government spending lower.

Wall Street as we knew it is not coming back, yet the quest for a soft landing is leading Congress and regulators to drag their feet on the structural reforms that are needed in the securities market. At a minimum, the derivatives contracts we are hearing so much about need to be made public. The longer that and other reforms are delayed, the larger the problem grows, as harmful business dealings continue to mount. Like continuing to build a tower after design flaws are discovered, the result of the delay will not be a softer landing, but a larger loss when the eventual collapse occurs.

To ease a transition, you have to see it coming farther in advance. An Earth-impact asteroid that is identified five years in advance can probably be redirected just by attaching sails to it. Hospitals that plan for the coming decline in health care can scale down by cutting back on hiring. Once the problem is here, options are more limited. General Motors’ most important options now are about what to include in the business plan it presents to the bankruptcy court. Hospitals that did not plan for the downturn may now have to decide the size of their layoffs. The problems on Wall Street were well known five years ago. Some of the fixes that were discussed then, in the papers, in board meetings, and in Congress, have still only been studied. Read Black Swan author Nassim Nicholas Taleb’s reform proposals and consider how much less painful the current situation might be if they had been phased in starting five years ago:

Ten principles for a Black Swan-proof world

Taleb’s ideas might seem drastic, but it is only because they are needed quickly to avoid compounding the current problems and creating a worse crisis next year than the one we saw last year. If they could be phased in over a period of years, they would not be so hard to take. But we did not get an early start, so we do not have the luxury of a soft landing now.