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  • The Week on the Hill

"A week is a long time in politics," former British Prime Minister Harold Wilson once remarked. In economics, it can be even longer. The crisis that started in the housing market, trashed the U.S. investment banking industry, and put taxpayers on the line for $700 billion (a partial down payment) has now spread with equal intensity across Europe and beyond. After a satisfying moment of reflection on the death of American capitalism, Europe's leaders are desperately trying to quell their own convulsions, and quarrelling with one another about it. The panic has spread to emerging markets, too. Stock markets tanked worldwide this week. The crisis has gone global.

This new international dimension complicates things. One bright spot for the U.S. economy of late has been exports. Domestic demand has done nothing to keep growth going these past few quarters. The economy avoided recession in the first half of the year only because demand overseas improved the trade balance. Even with that push from trade, the economy most likely moved into recession in the current quarter. (It will be a while before the official arbiters can confirm that.) If demand abroad now slumps the way it has at home, the outlook for the U.S. economy will be so much the worse.

This weekend, finance ministers gather in Washington for the annual meetings of the International Monetary Fund and World Bank. If these bodies have any role at all, it ought to include helping at times like this. Despite its recent invisibility, in fact, there is plenty that the IMF, especially, might do. Controversial though its role has been in the past, for instance in the Asian economic crisis of the late 1990s, the IMF has hard-won expertise in coping with financial breakdowns. It should have some tips for the Treasury Department on how best to tweak the new Troubled Asset Relief Program to make it more effective. More on that in a moment.

The meetings also provide an opportunity for collective action.

Some coordination has already occurred, including this week's cut in interest rates. But a joint statement that went beyond the usual platitudes would be welcome. Fiscal stimulus in one form or another -- tax cuts, bailouts, other kinds of public spending -- is going to be high on the agenda everywhere. Those policies would work better if world leaders could coordinate them. Also, some struggling middle-income nations might need help. Countries with big external deficits, needing to borrow from the global capital market, will be in trouble if the market seizes up. (America would be in the same boat were it not for the fact that the dollar is the main reserve currency. Whether the dollar will still have that privileged position when all this is over is another question.)

Once the immediate crisis is contained, financial regulation will need to be completely overhauled. The IMF should have a role here, too.

If this effort is going to succeed, regulators will have to pay much more attention to the international implications of their new rules.

It is no longer possible for any one country -- even one as big as the United States -- to design its financial regulations as though it were alone in the world. Tighter rules on the adequacy of financial firms' capital and/or liquidity, for instance, or on their executive-pay schemes (which many observers see as implicated in the excessive risk-taking of recent years) are unlikely to stick unless they are implemented across borders. In the short run, rules designed to promote financial safety can put a country's banks and other financial institutions at a competitive disadvantage. They will meet political resistance, and the more the crisis fades in people's memories, the more effective this resistance in the end will be.

International cooperation is difficult, but it is the only answer.

That is for the future -- it is a bit soon to talk of memories of this crisis fading. Things are still getting worse. The main question on the minds of politicians and experts attending the IMF's annual meeting is simply this: How much worse is this going to get? And what do we do about it, not next year and the year after, but right now?

Morris Goldstein, a fellow at the Peterson Institute for International Economics, a veteran of the IMF, and consistently among the most astute and level-headed analysts of the crisis, gave good answers at a presentation in Washington this week.

Goldstein offered two honest responses to the question of how much worse it was going to get. His answers: "We don't know" and "It all depends."

But he says he keeps three benchmarks in mind -- the depth and duration of previous recessions caused by extreme financial distress; the losses that financial firms had already acknowledged through writedowns, measured against losses still to come; and, finally, the prospects for the housing market, where the trouble all started, and where any lasting recovery will most likely have to begin, in the form of house prices hitting bottom.

All three indicators say the same thing: We are still in the middle of this, and so far as jobs and output outside finance are concerned, much worse is to come. Several studies have looked at the average duration of recessions induced by financial busts.

Goldstein pointed to one by Carmen Reinhart and Kenneth Rogoff. They looked at 18 financial crises (all in rich countries, post-1945) and found that growth slowed going into the crisis and then stayed low for two years. In the five worst cases, economic growth not only slowed but went negative for three years. These were the slumps in Spain in 1977, Norway in 1987, Finland in 1991, Sweden in 1991, and Japan in 1992 -- all somewhat comparable to the present emergency.

The track of house prices up to the onset of the meltdown went even higher in the U.S. than it did in the average of those five worst episodes. On average in those cases, prices then fell back to where they had been four years before the onset of the crisis. This would imply that U.S. house prices might only be halfway there, with a drop of another 15 to 20 percent still to go.

As for owning up to losses, estimates of those already in the system vary. Over the past year, these estimates have escalated to extraordinarily high numbers. Currently (taking no account of any further drop in house prices, and in the associated value of mortgage-backed securities), estimated losses in the finance industry broadly defined run to well over $1 trillion, and to perhaps as high as $2 trillion. Of this, only some $650 billion has been written down so far. However you look at it, the end of this is nowhere yet in sight.

What should the next steps be? Even after this week's cut in interest rates, Goldstein says he favors a second big fiscal stimulus package as well, unless there are early signs of improvement. World leaders could and should begin this weekend to prepare an internationally coordinated plan. Done that way, the effect of the whole would be greater than the sum of the parts.

Goldstein was relieved to see Congress enact a financial package, but he wants to see it improved -- and thinks it can be, for the most part, without new legislation (and further delay). Treasury should use the first $150 billion or so to buy bad mortgage-backed assets, he says. That would probably be enough to create a market and establish a fair value for the rest.

Armed with that information, U.S. officials should do a fresh evaluation of the solvency and capital adequacy of the big institutions that are important to the whole system. The government would shut down companies that are bordering on insolvency by using a resolution process like the one the Federal Deposit Insurance Corp. used for busted banks.

For the others, Treasury would use another $300 billion or so of the bailout money to drive a recapitalization program. Solvent firms would get some of this in exchange for shares (giving taxpayers some upside) and would agree to raise more capital on their own -- maybe matching the federal infusion -- from private markets and by suspending dividends.

That would leave $300 billion of the Treasury's pot for helping to restructure mortgages facing foreclosure, partly by expanding schemes already in place. Not every economist agrees with Goldstein that relieving the downward pressure on house prices is a good idea. Some say it only prolongs the agony. But I agree with Goldstein. In a crippled market, prices can undershoot the point they have to get back to, just as they overshot on the way up. Overreaction should be prevented if possible.

The news is bad, but not all bad. U.S. officials and Congress have recognized the gravity of the situation -- something that Japan took years, not months, to do in the 1990s -- and have taken some big, bold remedial actions.

To quote a different British prime minister, "This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."