As the credit bubble unravels, will the bad debts be written off, resulting in a debt-deflation spiral? Or will central banks do everything within their power, including the use of “unconventional methods” to prevent asset prices from falling? I suggest the latter outcome. The benefits to a deflation are deferred and dispersed, and require a considerable amount of pain first; while the benefits of bailing out financial institutions are immediate and concentrated. With 70% of Americans owning homes, public opinion generally favors rising, or at least not-falling home prices. It’s hard to see any political figure making a case for letting the system wash out and find its own leve.
Reuters reports :
- Fear that a hobbled banking sector may set off another Great Depression could force the U.S. government and Federal Reserve to take the unprecedented step of buying a broad range of assets, including stocks, according to one of the most bearish market analysts.
That extreme scenario, which would aim to stave off deflation and stabilize the economy, is evolving as the base case for Bernard Connolly, global strategist at Banque AIG in London.
- “Avoiding a depression is, unfortunately, going to have to involve either a large, quasi-permanent increase in the budget deficit — preferably tax cuts — or restoring overvaluation of equity prices,” Connolly said on Monday.
“If conventional monetary policy is not enough to produce that result, the government may have to buy equities, financed by the Fed,” Connolly said.
Legal changes would be needed to give the Federal Reserve and the U.S. government the authority to buy stocks. Currently the Federal Reserve can buy only debt issued by the Treasury, as well as U.S. agency debentures and mortgage-backed securities.
While Connolly already sees some parallels with the 1930s, he expects that a more pro-active central bank and government will probably help avert a repeat of that scenario today.
The build up of a credit bubble in recent years was similar to the late 1920s run-up to the Great Depression, he said.
- WASHINGTON — The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.