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The best and worst case scenarios
The best case scenario: The bad banks continue to be bought up, there is no run on hedge funds next Tuesday, only mid-sized European banks fail, money market funds keep on buying commercial paper, and the Fed and Treasury continue to operate on a case-by-case basis. Since Congress doesn't have to vote for something called "a bailout," it can give Paulson and Bernanke more operational freedom than they would have otherwise had. The American economy is in recession for two years and unemployment does not rise above eight or nine percent.
The worst case scenario: Credit markets freeze up within the next week and many businesses cannot meet their payrolls. Margin calls cannot be met and the NYSE shuts down for a week. Hardly anyone can get a mortgage so most home prices end up undefined rather than low. There is an emergency de facto nationalization of banks to keep the payments system moving. The Paulson plan is seen as a lost paradise. There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag. The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands. In the very worst case scenario, the Chinese bubble bursts too.
I still think some version of the best case scenario is more plausible, but I wish I could tell you I am sure.
Posted by Tyler Cowen on September 30, 2008 at 06:00 AM in Economics | Permalink
Comments
"The American economy is in recession for two years and unemployment does not rise above eight or nine percent."
!!! And that's "best case"?
Posted by: Alex at Sep 30, 2008 7:52:11 AM
Here is a (I think more likely) "best case:"
Nothing much happens. The stock market bounces around a bit, as do unemployment, etc., rates. Some financial institutions fail and are replaced by others and the economy continues to function without any major disruption. Those banks which most heeded government demands to make "politically correct" mortgages (Countrywide) vanish. Then, ... will Washington learn? I doubt it. Barney Frank & Company will keep making the same mistakes.
Posted by: Critic at Sep 30, 2008 8:30:40 AM
Let's add to the best case scenario: better decision-making practices by financial institutions in the long run (and less moral hazard due to the apparent political difficulties of getting an industry bailout), a less bubbly housing market in the future, and more flexibility for fiscal stimulus in the short run(without 700bn tied up in holding risky bad assets). The long run could be a world where the government has to put out fewer fires in which it may have helped fuel.
A smaller, more efficient (albeit less risky) financial sector might not be so bad either for sustainable long run economic growth.
Posted by: Scott Wentland at Sep 30, 2008 8:36:56 AM
A scary scenario is that the stock market temporarily bounces from yesterday's losses (as futures indicate it might) and skeptics conclude that Paulson was crying wolf and there is no revote on any bailout.
Of course, the meltdown scenario was always about the credit markets and not the stock market, but how many in the Congress or general public truly understand that?
The "buy on dips" reflex is very strong, and it's worked consistently for the past 25 years. Of course, any investor who followed this strategy consistently in 1929-32 got utterly wiped out.
Posted by: at Sep 30, 2008 9:05:15 AM
"any investor who followed this strategy consistently in 1929-32 got utterly wiped out"
Only if you bought with money you couldn't afford to let go of for many years. It's the stock market, risk and reward and all.
Buffett says that you don't need to buy a stock that you would care if the stock market shut down for 10 years. Where exactly is he wrong?
I think I read John Hussman say once that the 'duration' on stocks is something like 30 years on AVERAGE. He's been fully hedged for years. Think about that.
Posted by: Andrew at Sep 30, 2008 9:21:12 AM
Why are government and the taxpayer on the hook if hedge funds collapse?
Posted by: meter at Sep 30, 2008 9:22:29 AM
The recent financial crisis kept reminding me of Katrina -- the levee is breaking here and there, how many sand bags should we throw out to stop the leak? Will the levee fail catastrophically? Should people be evacuated? How long will it take for the city to recover from a flood assume there will be one? And once recovers, will it still be the same? ...
Once a mind is set on an analogy like this, the worst case scenario is ugly.
Posted by: Yan Li at Sep 30, 2008 9:40:12 AM
"Only if you bought with money you couldn't afford to let go of for many years."
Didn't quite a bit of the stock purchased between 1929 and 1932 end up worth 0, never to recover?
Posted by: M1EK at Sep 30, 2008 10:26:01 AM
In posts like this one I realize that I am a pitiful sadist.
Posted by: Lucas at Sep 30, 2008 11:03:21 AM
"Didn't quite a bit of the stock purchased between 1929 and 1932 end up worth 0, never to recover?"
Good point, and today we have easier diversification methods. On the other hand, go ask someone holding Lame and Brothers stock about it. Again, the same principle applies, don't own stock you can't afford to lose, for either a long time or forever. These periodic reminders of this lesson are what make the returns so good.
Posted by: Andrew at Sep 30, 2008 11:15:55 AM
Andrew, you moved the goalposts from "10 years" to "forever". And you could have been fairly diverse in 1929 and still ended up completely broke.
Posted by: M1EK at Sep 30, 2008 11:23:09 AM
Buying on dips would be a terrible strategy if we're in a 1929 situation. The stock market went down by 89 percent from the summer of 1929 to the summer of 1932, to levels not seen since the 19th century. And it took until 1954 -- TWENTY FIVE YEARS -- for those 1929 levels to be reached again.
Posted by: DBX at Sep 30, 2008 11:31:46 AM
I think that best case is pretty off. If you are being realistic.
What happens if it turns out better than you best case?
Do you stake your credibility on the assertion that "no outcome can possibly be better than this"?
Posted by: Jay at Sep 30, 2008 11:33:27 AM
Home prices in high value areas are already heading toward being undefined.
30 year fixed rates for jumbo loans are around 9% now. Nobody is buying unless they locked in a rate before 2 weeks ago. Within 10 weeks I expect you'll see virtually no homes over $500K sell unless the credit situation gets fixed.
Posted by: Martin at Sep 30, 2008 11:47:38 AM
There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag.
Wait, why would we have to do that? I can understand with huge banks -- there's all that counterparty risk from transactions that flow through them. Are hedge funds comparably central to the operation of the markets? Couldn't we let them collapse?
Posted by: Taeyoung at Sep 30, 2008 11:49:23 AM
As Friedrich Hayek wrote in 1932, “Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. ... To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about ...”
Posted by: Ylem at Sep 30, 2008 12:07:08 PM
Economist Jeffrey Miron says the bailout plan presented to Congress was the wrong solution to the crisis
CAMBRIDGE, Massachusetts (CNN) -- Congress has balked at the Bush administration's proposed $700 billion bailout of Wall Street. Under this plan, the Treasury would have bought the "troubled assets" of financial institutions in an attempt to avoid economic meltdown.
This bailout was a terrible idea. Here's why.
The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.
Worse, beginning in 1977 and even more in the 1990s and the early part of this century, [the Democrats in] Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared. [We can thank Chris Dodd, Barney Frank, Pelosi, et al, for this.]
This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.
Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.
The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.
The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.
Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.
In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.
Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.
Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.
Further, the current credit freeze is likely due to Wall Street's hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.
The costs of the bailout, moreover, are almost certainly being understated. The administration's claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.
If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.
The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients.
Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.
So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.
The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.
Posted by: dianeremarx at Sep 30, 2008 12:11:13 PM
This is not about the stock market! This is about house buyers being able to get mortgages. If they can't, what happens? House prices fall, because the desperate sell to vulture buyers and the low bar sets the market value.
What does that do to the retirement nest egg of the elderly? There will be huge numbers of new elderly poor--what a great way to hit back at Wall Street!
People lose confidence that they will come out of this thing ok, and put off major (car) and minor purchases. The economy slows, and factories close. Shipping of goods slows down to a trickle. Factory workers (those freeloaders!) and truckers will lose jobs.
As earnings drop, so will drop the price of publicly traded shares--and 401(k)'s will plummet.
How is this revenge plot against Wall Street going so far?
Oh, earnings all around are dropping--now tax revenues will crater. That's the money that pays police, firefighters and teachers. Bridges, tunnels, road repairs--all cut back or stopped altogether, as cities, towns, and state governments struggle to meet their obligations. And issue bonds to borrow money--from CHINA!
Posted by: Sandy at Sep 30, 2008 12:24:19 PM
This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.
The banks were not 'pressured' into subprime lending. They dove in feet first. Both Fannie and Freddie and the CRA have been around for decades without causing a spike in sub-prime loans.
Posted by: Scott de B. at Sep 30, 2008 12:31:22 PM
"There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag."
why does the government end up holding the bag. by what mechanism ?
Posted by: ed_finnerty at Sep 30, 2008 12:36:25 PM
The German economy has always prized stability and efficiency over wild growth and risk. When the wall came down and they absorbed East Germany, most experts said they'd never recover. But the Germany economy is based on making quality goods and selling them at the right price. They are stable, and just plug along, without a lot of fanfare but without a lot of bubbles and busts.
It's like the carburetor vs. fuel injector. The fuel injector is higher tech, more efficient... but you can't rebuild one if it goes.
Posted by: Hookers and Blow at Sep 30, 2008 12:46:27 PM
The recent financial crisis kept reminding me of Katrina
Reminds me of Ike and "certain death" for hundreds of thousands....
Posted by: at Sep 30, 2008 1:17:51 PM
"Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen."
A quick question: is there evidence that the credit markets are right now freezing or is this just a concern about what may soon happen?
I am having a hard time understanding all of this so pardon my ignorance on such a basic question. I have heard that Federal Reserve data suggests that loans are still being made in abundance that the vast majority of regional and local banks are still on firm footing. Is the problem simply that certain large banks are in trouble and is the solution for smaller banks to bring together lenders and creditors.
Posted by: pauld at Sep 30, 2008 1:38:23 PM
Here's my worst case scenario:
Bailout happens. Inflation increases, but home values continue to decline and wages remain flat. Home owners, with budgets already crunched beyond expectations, are burdened with even higher costs of living and default risk increases greatly. Defaults increase and home prices fall more. The bailout causes the interest rate the government borrows at to go up, moving money away from businesses and causes banks to expect higher interest rates from home buyers, puting further downward pressure on home prices. Scared money also goes from home and business loan to continuously roled over long positions on commodities, which people expect production not to increase for but demand to remain. Prices go up relative to income, and default risk goes up.
Credit markets freeze up within the next week and many businesses cannot meet their payrolls. Margin calls cannot be met and the NYSE shuts down for a week. Hardly anyone can get a mortgage so most home prices end up undefined rather than low. There is an emergency de facto nationalization of banks to keep the payments system moving. There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag. The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands. In the very worst case scenario, the Chinese bubble bursts too.
Posted by: aaron at Sep 30, 2008 1:40:00 PM
When the wall came down and they absorbed East Germany, most experts said they'd never recover.Funny, that. I saw Paul Volcker speak in 1988 or 1989 - during the course of his speech, he mentioned that he suspected that Germany would overtake the US, economically, rather than Japan, which concern was prevalent at the time. German reunification obviously threw a wrench into that, but, as you suggest, it may not have been permanent.
Posted by: kenga at Sep 30, 2008 1:45:38 PM
