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Recession causes and cures

Original post made by stephen levy, University South, on Apr 15, 2009

We usually identify and measure recessions by (1) the amount of job losses, (2) the reduction in the national production of goods and services (a decline in real gross domestic product, and (3) the result of these first two events: a sharp rise in unemployment rates. A recession is a prolonged period of economic downturn.

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Comments (4)

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Posted by Hal Plotkin
a resident of Midtown
on Apr 16, 2009 at 11:50 am

Hal Plotkin is a registered user.

I'm delighted to see this blog, Steve. I've learned so much from you over the years, it is a delight to see you writing here. Thank you.

Here is my question about the recession/depression.

The most troubling analysis I've read recently indicates that the real problem with the AIG bailout (not the phony diversion over bonuses), is that the federal government has stepped in and promised to pay the holders of AIG's credit default swaps 100 percent, in full, when loans go bad. Those instruments are held mostly by big banks and hedge funds, as you know. But to collect this money the banks and hedge funds have to push their borrowers into default. Thus, they have no real incentive to modify loans or work with borrowers. Instead, (as the WSJ reported yesterday) many are actually raising interest rates and such, in what looks like a clear effort to create the failures that will let them cash in their government backed credit default swaps at 100 percent, with no haircuts.

I've seen several columns that say this is why we can expect not a slow recovery but instead a continuing and perhaps even accelerating wave of bankruptcies and foreclosures in the year ahead. For example, see this link: Web Link -- cited on Joel Kotkin's New Geography blog.

What do you make of this argument/theory? Has our federal government inadvertently set up a dynamic that will protect the holders of credit default swaps at the expense of our larger economy? Or is this just a fringe effect that won't have much impact on our overall economy? I'd be very curious to know what you think...

Thanks again,

Hal




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Posted by stephen levy
a resident of University South
on Apr 16, 2009 at 4:24 pm

stephen levy is a registered user.

Hi Hal,

Thanks for the kind words. I just wrote a long answer, hit submit and watched it disappear into the ether. I forgot to do it offline so have no copy.

I will try and recreate the answer to your good question but now it may be Saturday until I can get to it again.

Steve


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Posted by stephen levy
a resident of University South
on Apr 17, 2009 at 2:07 pm

stephen levy is a registered user.

Hal,

I am not an expert in all of the technical aspects of CDS or the AIG bailout.

To me what is going on goes under the heading of "pick your poison".

My take is that the administrations (Bush and Obama) made a conscious decision to aid AIG knowing that the money would go partly to large banks and other investors. They certainly knew that the support for AIG would stop investors from having to negotiate with AIG regarding loss sharing—the inadvertent dynamic you mention.

But they believed that a bankruptcy for AIG or substantial losses to the CDS holders would pose more risk to the world's financial system. That is what President Obama has said consistently. This is part of the administration's broader theme that it is necessary to help Wall Street in order to help Main Street, meaning the broader economy. So they are helping the CDS holders not at the expense of the economy but in order to help the economy recover.

The administration is caught with difficult choices. They are trying to walk through the rain drops in the sense of stabilizing the financial system without taking over too many firms. This leads to some incentive structures that seem like they are rewarding "undeserving" institutions in order to help the economy.

They are making the same kind of decision in setting up the incentive system to encourage private investors to buy so-called toxic assets from banks. The investors get most of the rewards while taxpayers bear most of the risk. This will probably lead investors to bid "too high" for some bank assets but this may be the only way to get banks to sell the assets and clear space for more lending.

I think this approach along with the stimulus package and the housing initiatives have a good chance of working. But if we don't see progress by mid-summer my instinct is that the president will be true to his word and we will see Plan B.

The best antidote for families and the financial sector is an effective economic recovery and growth plan.


Like this comment
Posted by Peanut Gallery
a resident of Old Palo Alto
on Apr 18, 2009 at 10:34 am

Peanut Gallery is a registered user.

"amount of job loss" or "number of job losses," but not "amount of job losses." That and the confusion between the use of less and fewer ...


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