• Layoffs. Labor markets are reacting to the dramatic economic downturn more quickly than during previous cycles. Within the space of just a few months, unemployment around the globe has skyrocketed. As a result, it appears to be losing its character as a lagging indicator. The main reason for this is the deregulation of labor markets.

  • US & EMU. The US unemployment rate, for example, has jumped almost 2 percentage points over the last six months and, therefore, at the fastest pace in the last 35 years! At the end of this year, we expect a rate of 9%. That is fueling deflation risks (pages 4-7). For the eurozone, we are even projecting double-digit unemployment rates for 2010.

  • US programs. The time is, therefore, overdue for sweeping programs to reactivate the economy as well as the financial system. Obama’s fiscal stimulus package will pass Congress more quickly than anticipated. In contrast, investors rejected Geithner’s financial plan because – with the exception of TALF – it did not contain any details. The plan is, however, a step in the right direction (pages 2-3 & 8-10).

  • EMU programs. The large euro-zone countries have also approved fiscal packages running into the billions. Only Italy’s scope is limited. We expect the German programs to lift GDP by up to 1¼%. That will create up to 150k new jobs (pages 11-14).

  • Further topics:

    – Weekly Comment:     Change they cannot yet believe in (page 2).

    – EMU fiscal policy: When the going gets tougher and tougher (p. 15).

    – Data outlook: ZEW growth expectations to improve; US production to contract further (page 17).

    – Market outlook: Govies in demand again, EUR sideways (page 25).


Change they cannot yet believe in

US Treasury Secretary Tim Geithner unveiled the new Financial Stability Plan this week. His announcement pricked a bubble of excessive expectations, and the markets’ disappointment was clear as stocks fell, bonds rallied, and JPY and USD rose, signaling higher risk aversion. This is particularly unfortunate as Geithner had stressed at the outset that the new Administration was determined to deploy overwhelming force, in contrast to a policy strategy that had so far been reactive and behind the curve, and had therefore failed to restore confidence. The immediate market reaction paradoxically confirmed his assessment: investors and the public at large have lost confidence, and urgently need to see concrete and detailed measures – announcements are not enough anymore, and this week’s announcement came too soon. It would probably have been better to wait until more details had been worked out – but that was perhaps politically unfeasible or unwise. I think the markets’ disappointment was excessive, and reflects overblown expectations more than weaknesses in the strategy. Geithner’s overall assessment of the gravity of the situation was realistic and candid, the strategy is sound, the government’s determination inspires confidence and the commitment to transparency and direct support to households and firms should ensure public and political support. The new Administration is moving in the right direction, but the markets will need to see more concrete steps before they can believe in this change.

The market’s disappointment should not take away from the fact that the guiding principles and the overall strategy outlined this week are sound and should prove effective. Geithner emphasized that, building on the lessons of the present and past crises, the new strategy would be based on the following key principles:

1. A comprehensive and forceful policy response, formulated in forward looking way and erring on the side of too much action rather than too little.

2. A policy effort to be sustained until the recovery is firmly established, avoiding the risk of hitting the brakes too early.

3. Policies aimed at mobilizing and leveraging private capital, not simply substituting it.

4. A firm and consistent commitment not to allow further failures of financial institutions.

The promise of a comprehensive, forceful and sustained response should restore confidence, while leveraging private capital acknowledges the magnitude of the challenge and represents a commitment to exploit market mechanisms to the extent possible. Main drawback: The commitment not to hit the brakes too early will eventually fuel concerns on the exit strategy, posing a risk to bond yields. The strategy is built on three key pillars:

1. Bank recapitalization: Banks will have to undergo a forward looking and comprehensive stress test to determine whether they have sufficient capital to withstand the ongoing recession. If not, they will have access to a Financial Stability Trust that will provide a preferred security investment by the Treasury, convertible into common equity. This should be seen as a bridge to private capital to be eventually raised by the banks.

2. What we might call a “Bad Public-Private Partnership”, that is a creative take on the “Bad Bank” formula to take toxic assets off the banks’ balance sheets. The idea is to commit public capital to leverage at the same time private funds to purchase illiquid assets from the banks, mainly real-estate related assets. The partnership aspect would have two benefits: (a) increasing the available funds, to a total target of USD 1 trillion, starting with USD 500 bn; (b) to involve private asset managers in the pricing of the assets.

3. Lending boost: A new Consumer and Business Lending Initiative for up to USD 1 trillion. This will expand (fivefold) the Fed’s Term Asset-Backed Securities Lending Facility to revive the securitization market, which in the past accounted for nearly half of lending, and kick-start the generation of new loans.

Equally if not more important, a new housing market strategy: Geithner promised that in a few weeks the Administration will announce a new program aimed at reducing interest payments on existing mortgages and making new mortgage more affordable, to ensure a stabilization in the housing market and halt the current spiral of foreclosures and falling real estate prices.

I believe the new strategy goes exactly in the right direction in terms of determination and search for innovative solutions. However, this week’s announcement simply came too soon. Too many details are still undefined, raising uncomfortable questions. For example, the Public-Private Investment Fund seems aimed at getting private investors to price and buy toxic assets; but nobody is stopping private investors to price and buy toxic assets now, and it is not clear at this stage what additional incentive the PPIF will provide. It would have been better in my view to delay the announcement until more of the concrete details had been worked out, but I recognize that the pressure for unveiling the new strategy as soon as possible was enormous, and it was probably important to unveil the pillars of the strategy ahead of the G-7 meeting in Rome this weekend.

It is telling that Geithner started his speech this week with a bold commitment to a fundamentally new strategy that would unleash the full force of the US government against the crisis, but ended it warning that getting the economy and the financial system back on their feet would cost money, involve risks, and take time. The overall assessment of the gravity of the situation was realistic and candid, the strategy is sound, the determination inspires confidence and the commitment to transparency and direct support to households and firms should ensure public and political support. The new Administration is moving in the right direction, but the markets will need to see more concrete steps before they can believe in this change.