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Financial meltdown: What economic effects will it have?

Author: Roger M. Kubarych
September, 2008


Historic events over the past two months have fundamentally changed the US financial landscape, and additional shocks to the system are likely.

A collapse in investor confidence in the mortgage giants Fannie Mae and Freddie Mac, the two Government Sponsored Enterprises that together account for over half of the mortgage securities in the United States, led to an unprecedented takeover by the US Treasury.

But the bold action didn’t calm financial markets, far from it. Within days, Lehman Brothers came under attack, as market participants began to doubt its solvency, in view of its heavy exposure to mortgage securities, commercial real estate, and derivatives based on both of them. This time Treasury Secretary Paulson did an about face and challenged the rest of Wall Street to come up with its own plan to save Lehman. They couldn’t, and Lehman was compelled to seek the protection of the bankruptcy courts.

Fearing that the next attack could be directed against once-mighty Merrill Lynch, the firm’s leadership didn’t hesitate to agree to a merger with Bank of America. Now only two major independent investment banks are left, Goldman Sachs and Morgan Stanley, and one or both could seek a commercial banking partner, too.

Meanwhile, AIG, the nation’s largest insurance company, came under attack, as investors feared its exposures to mortgage securities and the derivatives markets could eat up its capital. Failing to broker a private-sector financial solution, the Fed, with US Treasury support, announced an $85 billion rescue package that effectively nationalizes AIG.

And this may not be the end of it. Some large commercial banks with extensive mortgage holdings have also suffered losses and need to bolster their capital to survive.

The bottom line is that the financial meltdown is serious, ongoing, and hard to manage.

What is not so clear are its economic effects. Will it precipitate a massive contraction in credit availability and collapse in consumer and business confidence, followed by a painful recession? Or is the “real” economy somehow shielded from the turmoil in the financial markets enough to avoid a severe downturn?

Here are some facts:

1.Since the beginning of the financial crisis last summer, the US economy has come close to recession but has managed to record positive growth, although naturally slower than before the collapse of the housing bubble. Real GDP is up 2.2% from July 2007 through end-June 2008. The economy has come through as well as it has because of a surprisingly strong improvement in real net exports, a result of robust global economic growth alongside a competitive dollar.

2. Commercial and industrial loans have gone up by $15.5% in the twelve months through August 2008. Consumer credit has gone up, too, by a more modest 4.9%. Even mortgage lending has risen, by about 5%. To be sure, lending standards have tightened considerably, but arguably they had been much too loose earlier. Worries about a potential credit crunch are not unfounded but may be exaggerated. There are still plenty of healthy banks and insurance companies in a position to make well-documented loans at reasonable (though admittedly wider) lending spreads.

3. Consumer confidence seems more linked to gasoline prices than to the stock market and has improved as gasoline prices have receded. Business sentiment has also steadied. But optimism does not extend to the job market, which has continued to weaken.

What can we expect next?

1. The US consumer is under stress. The unemployment rate has climbed above 6% and anxiety about job stability is high—and not just in the financial industry. Wage gains are barely keeping up with inflation. Housing prices are still falling. And for upper income people, recent stock market losses magnify the drop in household net worth. So personal consumption spending would have been weakening, even without the flare-up of financial market strains.

2. The outlook for business investment is mixed. Expansion seems to be limited to resource-based industries and exporters. By contrast, financial institutions will likely be slashing capital spending budgets to conserve cash.

3. The biggest question mark concerns exports. The financial shock is worldwide in its scope. Global economic growth is bound to slow. It already is in Europe. Plus the dollar has rebounded in the foreign currency markets, trimming US competitiveness somewhat. As of July, US exports were up more than 20% from a year ago, and over 10% in real terms. Those growth rates are unsustainable.

In conclusion, even if by some miracle the financial meltdown could be resolved tomorrow, there are powerful forces already at work that will suppress business activity—and not just in the US. The failure of several more financial institutions would make things somewhat worse; but saving them would not make economic prospects much better.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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