As I wrote in a column on my Web site last week, I believed that the bailouts had effectively tamed the financial crisis but that a greater crisis for the economy still lay ahead. There's no question in my mind as to the latter.
But after speaking to a friend I call the Lord of the Dark Matter, I now realize my view that the financial crisis was over may have been premature.
In his opinion, there is not enough high-quality collateral in the system to do the securitized lending that's part of the bailouts announced thus far. He believes the credit crisis is not close to being solved, as I had suggested. In fact, he says the deleveraging that's under way is about to accelerate.
What would be needed, he said, is something on the order of an epic Treasury issuance -- say, $1 trillion -- that would be monetized by the Federal Reserve, thereby allowing it to flood the system with collateral. In other words, rather than buying decent collateral, he believes, the Fed would have to supply cash for unsecured "trash," or high-quality nonliquid assets such as buildings, in order to solve the crisis.
This is a pretty radical thought he shared with me -- which, if true, means the credit crisis still has fairly far to go. There are no guarantees he is right, but he has been exactly right so far, every step of the way.
Liquidity injection does not a vaccine makeEven if the current financial crisis has been arrested for now, the severity of a recession here and around the world is a serious concern. And if my friend's view is correct, that would compound the crisis.
For the longest time, I suggested that the economy was going to hit the wall at some point. I believe that's what is now happening. To give you an example of what that might look like (though I don't often pay much attention to all those Fed surveys), this month's Philadelphia Fed business-outlook survey literally collapsed. It had registered 3.8 in September, but the October reading came in at minus 37.5, versus expectations of minus 10. I'm afraid we will see plenty of that ahead for the economy.
For example, most folks haven't yet stopped to consider how sizable the unemployment problem is likely to be. One of my biggest concerns is where jobs will come from as we head into this brutal environment. Doubtless that is on the mind of those 3,000workers who just received layoff notices -- from a company that one would not think of as particularly sensitive to gross domestic product.
Rising interest rates will only make a bad situation worse. Conforming mortgages are now around 7.5% (not that many people will be able to qualify in this environment anyway).
This disaster shows the fallacy of former Fed chief Alan Greenspan's belief in not preventing bubbles and instead working to clean up the aftermath. As everyone who lived through the 1920s learned, bubbles should be avoided at all costs. Bubbles cannot be fixed. They can only be prevented.