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Save the home lenders, save the world? If only it were that simple.
The just-announced federal takeover of Fannie Mae and Freddie Mac, the giant mortgage lenders, was certainly the right thing to do - and it was done fairly well, too. The plan will sustain institutions that play a crucial role in the economy, while holding down taxpayer costs by more or less cleaning out the stockholders.
But Sunday's action needs to be seen in a larger context - that of the attempt by the Federal Reserve and the Treasury Department to contain the fallout from the ongoing financial crisis. And that's a fight the feds seem to be losing.
We've come a long way from the days when Alan Greenspan declared a national housing bubble "most unlikely." There was indeed a bubble, and since it popped two years ago home prices have fallen faster than they did during the Great Depression.
Falling home prices, in turn, have led to the much-feared phenomenon of "debt deflation." Yes, deflation: prices are going up at the checkout counter, but the prices of assets, which are what matter for balance sheets, are dropping fast.
As the economist Irving Fisher observed way back in 1933, when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors' financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a "stampede to liquidate" is a severe economic slump.
That's what's happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged - their assets were mainly bought with borrowed money. As Paul McCulley of Pimco, the bond investor, put it in a recent essay titled "The Paradox of Deleveraging," lately just about every financial institution has been trying to reduce its leverage - but the plunge in asset values has nonetheless left these institutions with more debt relative to their assets than before.
And the numbers keep getting worse. In July 2007 Ben Bernanke suggested that subprime losses would be less than $100 billion. Well, last month write-downs by banks and other financial institutions passed the $500 billion mark - and the hits keep coming.
Which brings us to Fannie and Freddie. They're the only big financial institutions that haven't joined in the rush to deleverage, which is why they now account for about 70 percent of new mortgage loans. But their financial foundations have been undermined by debt deflation, even though their lending was more responsible than average. (A subprime borrower is basically someone whose credit wasn't good enough to qualify for a Fannie- or Freddie-backed mortgage.)
So Fannie and Freddie had to be rescued - otherwise debt deflation would have gotten much worse. Indeed, their financial troubles have already caused problems for would-be home buyers: mortgage rates are up sharply since earlier this year. With the federal takeover, which removes the pressure on the lenders' balance sheets, we should see mortgage rates drop again - which is definitely good news.
But is it enough? I doubt it.
The current U.S. financial crisis bears a strong resemblance to the crisis that hit Japan at the end of the 1980s, and led to a decade-long slump that worried many American economists, including both Mr. Bernanke and yours truly. We wondered whether the same thing could take place here - and economists at the Fed devised strategies that were supposed to prevent that from happening. Above all, the response to a Japan-type financial crisis was supposed to involve a very aggressive combination of interest-rate cuts and fiscal stimulus, designed to prevent the crisis from spilling over into a major slump in the real economy.
When the current crisis hit, Mr. Bernanke was indeed very aggressive about cutting interest rates and pushing funds into the private sector. But despite his cuts, credit became tighter, not easier. And the fiscal stimulus was both too small and poorly targeted, largely because the Bush administration refused to consider any measure that couldn't be labeled a tax cut.
As a result, as I suggested, the effort to contain the financial crisis seems to be failing. Asset prices are still falling, losses are still mounting, and the unemployment rate has just hit a five-year high. With each passing month, America is looking more and more Japanese.
So yes, the Fannie-Freddie rescue was a good thing. But it takes place in the context of a broader economic struggle - a struggle we seem to be losing.