The Big Bang of Bailouts

It wasn't long ago that most economists thought strong emerging markets could hold up the global economy, but now most developing countries are casualties of the crisis, as commodity prices plunge and consumer demand dries up. And there is no sign that the root of the global problem—the fact that banks lent way too much money to too many people and companies that were not worthy—is anywhere near solved. So far, banks have written off nearly a trillion dollars in losses, but estimates of the bad loans still on their books run about $1.7 trillion.

On the financial front, the recent rescue of Citigroup shows how the financial sector's problems are metastasizing. Subsidizing the September sale of Merrill Lynch cost the U.S. Treasury $38 billion; bailing out AIG in September and October cost $123 billion. The bill for Citigroup could come to $326 billion, and no one can be sure how many more major government interventions will be necessary, because no one knows how many toxic assets are still in the system and bank lending is months, maybe years, from returning to normal.

All leading indicators point south. Orders for Japanese machine tools, which are a strong indicator of how much companies are willing to spend on upgrading their plants, are dropping at the fastest rate since the early 1980s; world trade is projected to contract by more than 2 percent next year after several years of growth well above 4 percent per year; cross-border investment is likely to be down 50 percent this year compared with 2007 and will continue to dry up. The projections of rating agencies Moody's and Standard & Poor's for loan defaults are sharply up, including junk bonds whose risk premiums are at all-time highs.

The fundamental issue is fear. Despite the colossal problems in the U.S. economy, the dollar continues to strengthen, which just shows that investors fear other markets even more. Billions of dollars are flowing into three-year U.S. Treasury bills, whose interest rate is zero, so investors are merely trying to minimize losses, not make money. Clearly, the governments have not succeeded in restoring calm. Their efforts look improvised, confused and ineffective to the average consumer or investor. The poster child for this problem is the $700 billion Troubled Asset Relief Program in the United States. The bitter congressional debates over the program and its shifting purpose—from buying toxic assets to injecting cash—has left the public feeling that Washington isn't quite sure what it is doing. For many weeks now, the Treasury and the Fed have appeared to be constantly on the brink of unveiling yet another new program, leaving the impression that even they don't believe the current ones will work.

The second reason that the rescue efforts have failed is that no one was prepared for a crisis of such magnitude. Indeed, as the 9/11 Commission said about the terrorist strikes on New York and Washington, the reason the United States wasn't prepared was a lack of imagination. Previous crises—including the Latin American debt crisis of the early 1980s and the Asian financial crisis almost two decades later—were far less global in impact and far less complex in terms of the link between banks and the real economy. Indeed, an argument can be made that finance ministries and central banks are fighting this 21st-century conflagration with antiquated tools and 20th-century institutions. Postwar agencies like the World Bank and IMF have yet to rally the global effort that is required.

The question now is whether the current approach—gradually upping the ante and experimenting with new rescues— should be allowed to run its course, or whether a dramatic escalation is required. The argument for staying the course is that the billions already committed to the financial rescue are working their way through the system, and will eventually revive markets, perhaps sooner than anyone thinks. Global finance is very resilient, and there is, in any event, no dodging the pain of the credit crunch.