Sizing Up The Coming Recession

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Just as consumers are hitting the panic button, companies also are being squeezed, with many of them unable to access money precisely at a time when they need it. It has been nine months since the subprime crisis began, and it is now affecting virtually all credit products, including two of the safest of all: municipal bonds and corporate bonds issued by blue-chip companies. Now that the credit bubble has burst, even some perfectly reputable and solvent businesses are struggling for access to funds. Unless something happens to reverse these trends, a big drop in G.D.P. is inevitable.

Bernanke and Summers know this, of course. They are relying on the stimulus package signed by President Bush in February and lower interest rates to boost demand. From September through January, the Fed cut the federal funds rate from 5.25 percent to 3 percent. Cheaper borrowing costs make it attractive for families to refinance their mortgages and take out home-equity loans. In the boom years of 2004 to 2006, refis and home-equity cash-outs boosted consumer spending; the Fed is hoping to restart this game. Lower interest rates also bring down the value of the dollar, making American goods such as Boeing airplanes and Apple computers more competitive in world markets. In recent months, the one economic bright spot in the U.S. has been a surge in exports.

I doubt whether these policy changes will be enough to offset the slumping housing market and its psychic multiplier. But a bigger weakness in the optimistic view is its failure to fully address the crisis in the financial system. In the mild recessions of 1990-91 and 2001, we didn't see anything like the dislocation we are now witnessing. In some ways, the current situation more closely resembles the ruinous credit busts of the late 1800s, which shepherded in lengthy periods of economic contraction in that century's last three decades. According to the National Bureau of Economic Research, the U.S. was in recession from October 1873 to March 1879, March 1882 to May 1885, and January 1893 to June 1897 (with a brief respite from June 1894 to December 1895). The slump of the 1870s, which was precipitated by a collapse in the value of railway bonds—the era's subprime securities—and the ruin of banker Jay Cooke, lasted even longer than the Great Depression.

For those who prefer more-recent analogies, the relevant episode is the Nordic banking crisis of the late 1980s and early 1990s, which afflicted Norway, Sweden, and Finland, three highly developed countries that hitherto were considered exemplars of financial stability. In each of these cases, a lending boom that revealed poor risk management, ill-advised deregulation, and irresponsible macroeconomic policies preceded the financial blowup, and a severe recession followed. In Sweden, for example, banks were left with bad loans that came to more than 10 percent of G.D.P., and the economy went into a slump that lasted three years.

In all three countries, the initial reaction to the banking crisis was to try and drum up private-sector solutions for stricken institutions, such as new injections of capital or takeovers. But as panic spread, consumer psychology worsened, and G.D.P. growth turned negative, the authorities had little choice but to step in. The Norwegian government took over the three largest banks in the country, wiping out their shareholders. The Swedish government seized control of two of the biggest banks and split off their troubled assets into a state-owned company. The Finnish government took over more than 40 savings banks and combined them into a state-owned Savings Bank of Finland. Stefan Ingves, a senior official at the International Monetary Fund, was working for the Swedish government at the time. In a speech, he said that the principal lesson he learned was "that you cannot rely on the private sector or markets alone to solve systemic banking problems."

On this side of the Atlantic, we are still looking for market solutions to the credit crisis. First, there was the idea of setting up a privately funded "super" investment vehicle to digest the mess. In that scenario, bailout money would come from the banks themselves. Then came the sovereign wealth funds, with their injections of Middle Eastern and Asian cash into Citigroup and Merrill Lynch, and then a "voluntary" rate freeze on subprime mortgages. Now the big banks and Warren Buffett are vying to "rescue" the municipal-bond insurers. Behind the scenes, the Fed and the Treasury Department have been quietly orchestrating a mortgage bailout, using the Fed's lending facilities and other government-sponsored institutions, such as Fannie Mae and Freddie Mac, but even these efforts are too opaque and indirect to restore confidence, which is their ultimate goal. Lost trust takes a very long time to recover.

Until the solvency of the financial system is confronted head-on, with realistic write-offs and large-scale recapitalizations, there is little prospect of an economic recovery. Ask the Japanese. Back in the early 1990s, at the same time that the Nordic governments were recapitalizing their banks, the crony capitalists who ran Japan's financial system, which had undergone a similar boom-and-bust cycle, were busy trying to disguise the losses they had suffered. The result: an entire decade in which the Japanese economy hardly grew at all.

Bernanke, Summers, and other leading economists spent years studying how the Japanese got it so wrong. It is past time for them to read up on how the Scandinavians got it right.

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