This may be one mother of a financial crisis, but it is no perfect storm. Sure, we're in a credit crunch. Interbank lending is dismal. The stock market and housing market are freefalling. The financial system is disintegrating. In the words of Paul Krugman, "the economy is rushing downhill."
But while the turmoil is driving down asset prices and throwing financial companies into bankruptcy, there are many pockets of strength. Among them:
* The core of the crisis is the US, but the US is currently a debtor nation. In the 1930s the US was also at the epicenter of the crisis, but the US was a loaner nation, so lots of other countries were hit by the US withdrawing funding. This crisis won't spiral in that way.
* There would be a huge problem if foreign lenders lost confidence in the US, but that's not likely as the US dollar is strong. In fact, the US dollar is out-performing the euro, which is (was) its main rival. The euro is emerging as an unsafe place to store money, partly because Europe has no central authority to bail out European banks. (The countries that hold the majority of US debt, like China and Japan, do not want the US dollar to fall. Those governments face extreme domestic pressure to preserve the value of their reserves. The dollar is strong also because US banks are less leveraged than their international counterparts, meaning that while US banks caused the crisis, they're not suffering too much from it.)
* The TED Spread (difference between the Treasury bill rate and the rate at which banks lend to each other) is falling today, usually a sign that the crisis is over. Todays' Libor also indicates an unfreezing of the money markets, thanks to effective government intervention in England.
It seems that the biggest dark cloud on the horizon is inflation, and that's no small threat. I believe inflation has already hit 3.5%, and the bailout is dumping a lot of money into the system that will cause more inflationary pressure. Some economists are now predicting there will be no recession, but a couple of years of "soggy economy".
The US faces enormous short-term challenges due to its huge deficit and need to reduce consumption, increase saving, and improve production. Canada will face some adjustment issues during that phase. But in Canada, most other economic indicators are strong: income, housing starts, employment, fiscal surplus, funding of CPP... The one bad area is the manufacturing sector in Ontario, and since the financial crisis has driven the Canadian dollar back down below 80 cents US, that should pick up.
Long term, it looks like the US isn't going to cede its supremacy in the world economy, and might emerge even stronger than before. Stats like birth rates, immigration, productivity and innovation all indicate that the US and Canada will do well in the 25 years to come.
At least a little of the current doom and gloom story is cooked up. I attended a lecture by political economist Eric Helleiner last week, and he said the Globe & Mail has recently been asking academics (including himself) to write articles about why we're about to experience a great depression again. It seems to be a case of: be depressing or don't get published.
There is a lot of rebuilding to do, and the biggest threat may be that as the crisis abates, our determination to reform the financial system might wane. Another problem is that, unlike the years after the great depression, there are no clear leaders who are trusted by other countries anymore. The Bank for International Settlements, which is important in these sorts of reforms, only includes the 55 richest countries. Another problem is structural: the world's largest economy, the US, requires agreement by Congress to pass anything.
Some of the best suggestions I have heard for reform are:
* We need not just more regulations, but better regulations. The approach of Basel II was pro-cyclical and that has hurt us.
* We need to take action to dampen the boom and bust cycles. For example, in boom times, make financial institutions pay into an insurance fund for bailouts required in bust times.
* The US needs to clean up its act. For example, it is relaxing its "mark to market" requirements (valuation by market value not book value), which gives its companies a competitive advantage and encourages others to lower their standards.