‘Pre-empting another banking crisis is critical’

There is no chance that the global economy will slip into a 1930s-style Great Depression, but the Barack Obama administration must pre-empt a financial meltdown similar to that of 2008, says Economics Nobel Laureate Robert A Mundell.

Responding to questions from DNA a media interaction in Hong Kong on Wednesday, Mundell, who won the Nobel Prize in 1999 for his analysis of monetary and fiscal policy under different exchange rate regimes, said the Obama administration “has to do something about the insolvent US banking system” as otherwise it would be “very bad for the market and for all of Obama’s plans”. Excerpts:

On the risks of a Great Depression-style seizure of the global economy.
There’s no chance of that. The Great Depression came about because you had a 30% deflation in three years of all major industrialised countries, including the US, Germany, Japan, Britain and France. That came about because all the countries were tied to gold, although Britain got off the gold standard in 1931. Indicatively, if you’d had a gold standard in 2007, when there was a serious liquidity crisis, it would have cracked up the whole system. But you now have an expansionary system, and central banks can create as much money as they want. So there’s no risk of another Great Depression.

On the prospects of success of the Obama administration’s stimulus package.
The US Senate passed a $1 trillion stimulus package yesterday, which is to be negotiated with the House of Representatives. Yet, the markets responded unfavourably because there was a promise of a plan in (US Treasury Secretary) Timothy Geithner’s proposal, but it didn’t materialise.

The Obama administration has to do something about insolvent banks. There are half a dozen big banks that are technically insolvent if they mark their asset values to market. The government must pre-empt a crisis, because if another banking crisis erupts, it would be bad for the market and for all of Obama’s plans.

The problem is one of valuation. How do you start a market: you put something in and ask for bids. But banks cannot afford to make a bid lower than they have on their books because it would undermine their whole capital structure and show them up as insolvent. So you have to make banks more secure first. It’s very difficult, but it has to be done.

On how the financial meltdown of 2008 could have been averted
The meltdown could have been averted even as late as the third quarter of 2008. It wasn’t averted because the Federal Reserve screwed up. It’s mistake was that it didn’t stop the appreciation of the dollar in the second half of last year. Falling gold prices and a soaring dollar were symptoms of a shortage of US dollar liquidity. If the Fed had bought foreign exchange to pre-empt the dollar appreciation, there would probably have been no financial crisis at all.

Instead, Ben Bernanke, in his obsession with inflation-targeting, allowed the dollar to appreciate. What this did was to overvalue US dollar assets, including all fixed-income securities and mortgages, and tipped Lehman Brothers and other banks over the edge. Lehman was too big to fail, and the Fed let it fail, which was a colossal mistake because it had a contagion effect.

In effect, the Fed cut off an economic recovery just when it was stabilising and tipped the economy into a recession

On the way ahead out of the crisis
The US administration should first increase spending without increasing money supply. It can do this by creating a new instrument by issuing Dated Spending Vouchers (DSVs) for about $500 billion, valid for three months, to US citizens to spend. These work like pre-paid gift certificates, and retailers can use these DSVs as a tax credit. The advantages of this are that it’s a flexible model, which can be replicated. And although $500 billion doesn’t sound like much, it’s about 15% of quarterly GDP.

Second, the US administration should reduce corporate profit tax from 35% to 15%. It should let banks and corporation s recapitalise and become competitive. Germany has already done this.

Third, the dollar-euro exchange rate should be stabilised, at between $1.20 and $1.40 and use that as a basis for establishing a new world currency.
The rest of the world should likewise stabilise exchange rates and support the formation of a world currency.

More specifically, if the major developed economies do not fall in line, Asian governments should, create an Asian Monetary Fund and perhaps even move towards an Asian currency.

On the economic outlook ahead
That depends on the policy responses. If these recommendations are implemented, I believe the US economy can be on the track of expansion by the middle of this year.
But if not, the outlook is pessimistic: negative growth for most of 2009, a rise in unemployment, perhaps bank collapses and rise in corporate insolvencies. Overall, a decline in US leadership in the world, without the prospect of a recovery in the Europe until 2010.