The current financial crisis is the result of very large declines in asset prices, whose epicenter is the housing market. We had a bubble, trillions of dollars in bets were made on the assumption it would continue, and it didn’t. The ultimate cost of a bailout (and therefore its feasibility given limited resources) is, at this point, determined by the volume of net asset deflation minus pre-existing equity of financial intermediaries (which, due to their extreme leverage, was minimal). So far so bad.
But it could get much worse. The world has almost certainly entered into a recession. The current decline in US consumer spending, the first since the sharp V-slump of the early 1990s, is a bad sign. As the downturn picks up speed, it will add to the quantity of distressed assets: new corporate paper gone bad, further declines in equities, even greater distress in housing. This could increase the amount of implicit writeoffs and expose even more counterparties to default risk. The price tag of a bailout would lurch further out of reach.
Consider, for instance, the effect of an announcement by General Motors that it is filing for bankruptcy. For some time the markets have told us this is a 50-50 possibility; with car sales plunging and the apparent desperation of GM management in its merger maneuvers, it has to be an even greater possibility today. This would be taken as a sign by almost everyone that a positive feedback loop from the real sector to the financial sector is beginning to take form, and the consequences would not be pretty.
Of course, no one knows what the future holds in store. We may yet waltz out of this with only a trillion or two in losses to show for our fears of impending doom. That looks like the best-case scenario. As for me, I’m worried about positive feedback and the risk that even the best-designed bailout (better than what is now on the table) will not be enough. This is why I think that what I originally called Plan B, and now stands as Plan C or D—public banking—ought to be given immediate consideration. Why should we pin all our hopes on a bailout that may fail to catch up with its moving target?
Well, the old fashioned macro name for positive feedback loop is "multiplier," and there is certainly the potential for a financial one (or "financial accelerator," if you prefer, and as some of the lit uses, including some old stuff by Bernanke).
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