The Wall Street Meltdown

New York City -- With the bankruptcy of Lehman and the sale of Merrill this weekend, coming so soon on the heels of the federal seizure of Fannie Mae and Freddie Mac, this financial meltdown now ranks among the worst ever. We've got a panic, if not as bad as the fabled ones of 1929, 1907 and 1893, of the same frightening order. If not a category 4, we have a category 3.  What is amazing, so far, however, is that the panic has not yet led to a sharp contraction in the US and global economies as most panics generally have. It's worth taking a minute to consider what might or might not be different this time.

Recessions have generally grown less severe in the last century. The customary reasons cited are: the expanded role of the Fed (in 1907, it was JP Morgan, not the Fed Chairman locking up captains of Wall Street in his conference room to work out a solution), a learning curve in monetary policy, better data thanks to computers, the move from manufacturing to less cyclical services that don't have inventory buildups and then liquidation and, recently, the globalization of the economy that provides deeper and broader liquidity. That's the good news.  Recessions are now much less frequent than in the past and milder. Unemployment customarily went well into double digits in the recessions of yore whereas it barely brushed 6.5% in the last recession.

The bad news, however, is that the financial system has grown so complex that no one really understands its interactions. In a world of ever more complex derivatives, it appears that even individual companies have trouble understanding their exposure.  Accounting rules, ratings standards and regulation have not kept up with financial innovation.  Indeed, one can argue that the story of the American economy over the last eight years has been one of trying to make up through leverage and other financial means what the economy was not providing in real expansion.

When any country begins to depend on financial engineering to accomplish what it cannot achieve through real engineering it is in a dangrous position. The example of the Asian financial crisis showed that a credit contraction can quickly lead to a real economy contraction.  It took the Asian economies years to recover from the 1998 crisis.  The United States is in a somewhat better position than developing countries because we borrow in our own currency.  Nonetheless, any drop in the willingness of our creditors, notably China, to buy our paper as in the Fannie and Freddie auctions leading up to their seizure by the government, could send shockwaves through the real economy.

It would be naive to try to predict what's in store for Wall Street in the next few weeks let alone the real economy.  One reason that Merrill CEO John Thain reportedly decided to sell his company this weekend to Bank of America--beating out Lehman which had hoped for a deal with BOA--was that he expected Merrill to be the next target of shorts. With Lehman and Merrill out of the way, the shorts will now turn to the next weakest company, perhaps Wamu.  One can say with some certainty that the fireworks are probably not over.

In the short term, the problems on Wall Street are a strong argument for a second stimulus package that as I have argued should address some of our long-term problems as well, notably high energy costs.  A tax credit for weatherization, for example, would not only have stimulus value but would also insulate Americans from fuel cost volatility this winter.

In the long term, the current crisis underscores more than ever the need to create an economy that creates real value and wealth for the American people rather than tries to make up for the loss of industries and anemic growth through ultimately unsustainable financial wizardry.