Outlook 2009 (Bailouts): At what cost?

The cost of all these policy measures aimed at saving the financial system is a lot cheaper than not doing it.

The only thing that has come even close to the scale of the global financial crisis has been the scale of the policy response. Central banks around the world have injected trillions of dollars into their financial systems. Governments across the Americas, Europe and Asia have taken stakes in, or even fully nationalized, their banks. The International Monetary Fund, long the world’s fiscal disciplinarian, has advocated that countries enact big stimulus packages.

This aggressiveness is all to the good, in my opinion. History teaches clearly that in the face of financial panic, the risk is underdoing it, not overdoing it. The U.S. government tried outright austerity following the crash of 1929, generally tightening monetary and fiscal policy; the result was a depression that didn’t end until the Second World War. The Japanese government tried gradualism following the crash of 1990, taking nine years to get interest rates to zero; the economy still hasn’t bottomed.

What policy-makers now are trying to forestall most urgently is a deflationary spiral. That’s what happens when a financial crisis squeezes both credit and confidence so tightly that private demand collapses and prices economy-wide begin falling. Such deflation then feeds on itself, as consumers defer spending in the expectation of even cheaper prices ahead, even as the real burden of debt they’ve already taken on intensifies. Monetary policy becomes impotent because nominal interest rates cannot fall below zero, leaving real interest rates inappropriately positive. Getting out of such a deflationary spiral, which characterized 1930s America and 1990s Japan, is far more difficult and costly than preventing it in the first place.

So when I’m asked about the cost of all these policy measures aimed at saving the financial system, my first and most important answer is: It’s a lot cheaper than not doing it.

Frankly, it’s the only answer I can give with any confidence. A full accounting of the direct and indirect costs, either in the United States or around the world, won’t be possible except through the lens of history. But I can share some initial thoughts — and remember that I’m looking just at the cost of the response, not the cost of the crisis itself, which already runs into the tens of trillions of dollars worldwide in lost income and destroyed wealth.

First there will be a large direct fiscal cost. In the U.S., the bill for all the financial-system-related commitments undertaken by the government stood at about $8 trillion as of the end of November, or more than half a year’s GDP. But most of this represents an expansion of the government’s balance sheet — a lot of debt, but a lot of assets on the other side of the ledger. (The taxpayer may even turn a profit from some of it.) We estimate net new U.S. government borrowing (deficit) to total “only” about $2 trillion over fiscal 2008 and 2009, including the stimulus measures in response to the economic effects of the financial crisis.

That’s a lot of money, but would only raise the U.S. government’s net debt from 44% to 57% of GDP — still lower than the 71% burden in Canada at the 1995 peak, or the roughly 90% current burden in Japan or Italy. The fiscal response to the recent crisis will not itself destroy U.S. public finances, in my opinion.

There also may be an inflationary cost down the road. The fundamental money equation is MV=PQ, which states that the size of the money multiplied by its velocity (the number of times it turns over through transactions) equals the size of the nominal economy (price multiplied by quantity). Velocity has collapsed as banks, companies and consumers hoard cash, requiring the money supply to expand dramatically to prevent deflation. It’s not clear that even the 833% annualized rate of expansion in the U.S. monetary base over the past three months is enough to do it. But when risk aversion begins to abate and money starts circulating more normally, as will happen at some point, the Fed must act quickly to drain liquidity — or inflation will take off. The risk is that the Fed and other central banks won’t be quick enough. This is in fact a risk they’re quite willing to take at this point, as inflation is a much more familiar and solvable problem than deflation.

Further down the line will almost certainly come costs to the dynamism of the U.S. and global economies, upon the seemingly inevitable aggressive re-regulation of the financial sector and the re-intrusion of the less efficient public sector into the economy. These costs will probably never be definable, but may be the largest of all, if belief in the free market capitalism that had previously done so much to raise global living standards is irretrievably lost.

As large as these costs may be, I stand by my statement that the cost of governments’ not acting would be higher. That should tell you just what kind of threat this global crisis poses.

David Wolf is head of Canadian economics and chief strategist at Merrill Lynch Canada.