• Cover Story
• Table of
  Contents
• Contents By
  Topic
• Columns
  • Brownstein
  • Cook
  • Crook
  • Powers
  • Rauch
  • Stokes
  • Schneider
  • Taylor Jr.
• Regular
  Features
  • Hotline Extra
  • Inside Washington
  • Insiders Poll
  • K Street Corridor
  • People
  • The Week on the Hill

What if nothing works?

What if the government's response doesn't end the paralysis that is promp-ting banks and businesses to hoard their cash? Would that be so bad? Would the economic down-turn that President Bush warned about be a better

alternative than an ultimately open-ended government commitment to keep injecting money into the financial system until the crisis eases?

That line of argument can be heard on both the left and the right, and it helps explain, in part, why so many House members voted against the initial rescue package.

Robert Borosage, a prominent liberal critic of Republican economic policy, says that a depression might have its advantages. "Depressions have some salutary effects: The scoundrels go belly-up; the weakest get purged. And, in the wake of the disaster, people demand strict regulation of the money lenders to keep their greed in check, and government spends money on the real economy to put people back to work."

And on the right, here's a similar argument from Jeffrey Miron, a senior lecturer in economics at Harvard University: "Talk of Armageddon ... is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen."

Treasury Secretary Henry Paulson Jr. rejects such scenarios, predicting that the credit crisis would spread worldwide and so damage American economic prospects that European and Chinese investors, and even healthy companies in the United States, would be reluctant to risk lending money to American businesses and consumers.

To Al Martinez, a Los Angeles Times columnist who grew up during the Great Depression, it feels like another one is coming. "It's all anyone talks about now. Not the trillion-dollar war, not gasoline prices, not who won the Emmys or how the Dodgers are doing, but how long it's going to be before the bread lines form and the soup kitchens open."

On that topic, the stock market demonstrated a faculty for dramatic irony during Monday's swoon, when the only issue in the Standard & Poor's 500 index to post a gain was Campbell's Soup Co. Boom times ahead for soup kitchens, perhaps.

Most economists still view a depression as extremely unlikely. Michael Mussa, a former research director at the International Monetary Fund, says he was pretty sanguine that the economy would squeak through with only a mild slowdown this year -- until two or three weeks ago. The paralysis in the credit markets, he said, has made a recession nearly certain, and if the freeze continues for several more weeks, "a serious recession, as bad as any [since World War II] is on the table."

Mussa strongly believes, nevertheless, that this recession would be much more like the deep recessions of the 1970s and '80s than the Great Depression, when the U.S. economy shrank by a third, half of the banks closed, the stock market fell by 90 percent, and the unemployment rate reached 25 percent. He has a long list of reasons for this relative optimism, beginning with two crucial assertions: There is enough credit at the disposal of world governments to convince panicked investors that the financial system won't collapse; and, despite the hesitation in Congress, the political will exists to commit these funds.

In a series of lectures and interviews from 2004 to '07, current Federal Reserve Board Chairman Ben Bernanke said he took away a crucial lesson from studying the Great Depression: Government failed to do what it could have done, and people lost faith in government.

Mussa admits that huge injections of lending by the Federal Reserve and other central banks haven't yet restored confidence. On Monday alone, the Fed added $630 billion to the financial system -- and the credit shortage actually got worse. Mussa also concedes that the initial House vote against the bailout may have long-lasting effects on investors' faith in government.

Even executives whose businesses are relatively free of debt believe that the economy is at risk. Take Dave Dysinger, owner of Dysinger Inc., a small precision-machining company in Dayton, Ohio, that serves the energy and machine tool industries. After 35 years in business, Dysinger said, he has learned to plan carefully for downturns, and he predicted that his company could weather a cutoff in its credit. "I have had the opportunity several times to go out of business, and I learned from those experiences," Dysinger said. "We have a strong balance sheet, so we're not affected" by the credit shortage.

Nevertheless, Dysinger contends that the federal rescue must succeed. "I understand that the economy cannot continue to grow without credit."

On a larger scale, that is also the conclusion of the nation's business leaders, who only recently mobilized to lobby for the rescue. On Tuesday, the Business Roundtable enlisted 90 CEOs of the country's largest corporations for a conference call. The participants reported that the credit squeeze had begun to affect a wide array of industries, according to roundtable President John Castellani. "Petrochemicals, forest products, business services, consumer products -- it was really across the board," he said. While the cash position of most of his members is strong, Castellani reported, that's not always the case for their customers -- other businesses -- some of which are cutting back because demand for their goods and services is dropping.

But roundtable members also understand that the government alone cannot rescue the financial system, he said. "I think there is a recognition that [the rescue plan] is necessary but not sufficient" to end the crisis. If the credit crisis doesn't ease, Castellani said, "then we think the economy does face serious harm."

So what is the worst-case scenario? Here's what financial doomsday might look like in Dave Dysinger's hometown, just about the time that the next president will be taking office.

January 15, 2009

Mondays haven't been good days in most places lately, but this Monday in Dayton is worse because a freezing rain fell overnight. In a coffee shop on the south side of town, a television is tuned to CNN with the sound turned down, just in case.

For months, Mondays have been the worst days for the stock market, which has fallen about 50 percent from it peak in October 2007. Now, the Dow Jones industrial average is at 7,350. Most of the breakfast customers are retirees who have stoically watched their nest eggs disappear. A number of them drolly call themselves "ex-retirees," though most have found only part-time work or none at all.

They know of course, that the stock market is just a symptom of what is really ailing the economy. The problem is with the banks, which won't lend money even though the government keeps begging them to. Since December, the Federal Reserve has been trying to give money away -- lending at 0.5 percent interest rates -- but the big banks aren't interested. The spread between the Fed's rates and what it actually costs to take out a loan is off the charts -- interest rates briefly hit 10 percent for collateralized loans -- and people are saying that the Fed doesn't really control interest rates any more. The government is struggling to keep up with hundreds of bank failures, and Treasury is selling $100 billion in new debt to replenish the Federal Deposit Insurance Corp.'s depleted holdings that have gone to reimburse depositors.

People in Dayton know what it feels like when the bottom is dropping out, and that's what is happening now. Businesses that depended on credit lines from their banks for month-to-month expenses are suddenly closing their doors -- stores and gas stations and dry cleaners. A handful of companies had been supplying all the janitorial services for office buildings in the area, but now those companies are out of business and no one can get their offices cleaned. Even businesses that had been careful to keep their debt low are shutting down because so many of their customers weren't as careful. "Old-economy" employers knew the drill. Dayton-based auto parts maker Delphi had already shrunk from 15,000 workers in 1999 to 4,000 last summer, so it was no surprise when the auto-industry bankruptcies resulted in more layoffs. "New Economy" companies -- such as LexisNexis, hit by the implosions in the newspaper industry -- are also laying off hundreds in Dayton.

Like most sizable companies, these businesses have found it extremely expensive to roll over their debt to invest in new capital equipment. As a result, capital spending has stopped. Emergency tax breaks from Washington weren't enough to overcome the paralysis. Productivity growth has halted despite the decline in employment, and economists are now wondering if the remarkable growth in productivity that began in the 1990s had less to do with the Internet than with capital goods bought with debt that will never be paid off.

In Dysinger's town, almost everyone is carrying thousands of dollars in credit card debt at interest rates of 25 percent or more and has long since reached the credit limit. On the bright side, the flood of junk mail offering new credit cards has slowed to a trickle.

The unemployment rate is galloping upward at the rate of half a percentage point a month. In Dayton, where the rate was already 7.5 percent before the crisis, unemployment is approaching 9 percent. Nationwide, 2 million people have lost their jobs since September.

Most people don't understand why the government rescue isn't working, but the answer is pretty simple -- investors and consumers don't believe that the government will, or even can, solve the problem on its own. The several trillion dollars that major governments were able to pour into the world financial system since August was dwarfed by the loss of many more trillions from the crashing of the bond and derivatives markets, which had been constructed on bets that such a catastrophic loss of confidence was impossible.

Unlike debt based on a hard asset such as a railroad or a factory, much of this borrowing was based on the paper value of assets that were ultimately built on debt themselves -- a Ponzi scheme through which the world conned itself. The effects were global because American debt was so popular before the crisis, and that's why there is no massive inflow of foreign capital. Chinese, Japanese, and European investors have problems of their own, and they have stopped funding economic growth in the United States. This is the "current account crash" that economists have been warning of for years. When international investors stopped buying assets priced in dollars, the dollar fell by another 30 percent, and interest rates shot up.

Not that the rest of the world is much better off than the United States. Globally, growth is expected to fall to about 2 percent in 2009, a stunning deceleration from the 4.95 percent rate in 2007. Fast-growing economies such as China's, where output is heavily tied to the United States, have been hammered by the decline in the dollar and by lower demand for goods. And governments have been generally unwilling to commit taxpayer funds to deal with the manifestations of the crisis outside their borders.

All of this has tightened the credit crunch from the top to the bottom of the financial system, and that's why, as they say in Dayton, you couldn't get a dime out of a loan officer's pocket with a crowbar and a bucket of axle grease.

The cumulative effects of the credit paralysis have overwhelmed the natural tendency of the economy to adjust. During expansions, for example, slower growth lowers prices, which increases demand and restores growth. Instead, the cycle has been vicious. Less lending depresses growth, which makes more businesses insolvent, which further depresses lending and thus drives output down even more. There have been some benefits -- oil has fallen to less than $70 a barrel, for example, but the Organization of Petroleum Exporting Countries has been more disciplined in policing output than in past recessions and has thus arrested a potential fall in oil prices that might have really benefited the United States.

The president-elect and congressional leaders have advanced an array of plans -- pooling the state and federal trust funds, for example, or issuing bonds tied to federal property -- but markets have stopped reacting to government proposals because nothing Washington has done has worked. Besides, the government's new obligations have already added trillions to the national debt, reinforcing the flight from dollar-denominated assets and depressing demand for Treasury bills. In fact, for the first time, a major effort to auction Treasury bills last month had no takers -- not one.

After the government intervention last fall, those on the left and the right who argued that the market should be left to sort out the crisis are getting their wish.