Dani Rodrik, writing last week, is one of several to compare the current US financial crisis to the 1997 crisis in Thailand:
The financial crisis that has developed around subprime mortgages is so so astounding in so many different ways that, like many others I suppose, I am still having difficulty getting my mind around it. The whole thing is a big surprise for me. I would have been pretty ready to assert, as late as 6 months ago, that financial crises of this magnitude had become solely a developing-country phenomenon and that rich countries had developed the regulatory and other mechanisms that would prevent them from getting into such a mess. Yes, there would be smaller scale hiccups, such as the S&Ls or LTCM, but you certainly couldn't have a meltdown a la East Asia 1997-98 or Mexico 1994 in an economy such as the U.S.
Now we know that I would have been wrong. What is happening in the U.S. is no different from what took place in Thailand in 1997 or in Argentina in 1999, with the entire financial sector going belly-up. The only thing that remains to be seen is whether the costs to the real economy will be as high too. The rough rule of thumb for emerging markets is that banking crises are associated with an output loss of around 10% (see here for example).
And yet, in a way, an analogy to Thailand makes for a hopeful scenario. The Asian crisis of 1997-8 caused horrendous pain: GDP dropped steeply everywhere, and there was a sharp slowdown in growth. But it was brief. The next year, Asia started growing at its old rates again-- the fastest in the world-- and it's been booming ever since. The Asian countries had the good fortune, perhaps, that the IMF meddled. The IMF was accused of "shock therapy," but it claimed that the reforms it pushed on the Asian countries were necessary for long-term growth. We don't know the counter-factual, i.e., what would have happened if the IMF had not intervened. But the subsequent economic success seems to vindicate the IMF.
In Japan, which experienced a real estate bubble and bust and then a financial crisis in 1995, the government was more interventionist. The crisis there lasted much longer.
On balance, I think Paulson's bailout plan is most likely to make matters worse. There may be an ideal solution that shores up the financial system without costing the taxpayer too much. But we're unlikely to find it. The whole problem is fiendishly complex. Nobody understands it all. People who understand some parts of it are likely to have blind spots. And any action undertaken, even the most well-designed, will create major perverse incentives as private-sector agents try to position themselves to benefit from the next bailout.
I'm not saying "do nothing." Certain lines must be held at all cost, e.g., deposit insurance: if commercial banks fail, the FDIC must be ready to give despositors their money back. Other creative measures might be taken...
For example, just to brainstorm, maybe the government could offer to buy back the homes of people who can't pay their mortgages at purchase price - 25%. The government could pay this money to the bank, then pay the bank a bit more (but not all; banks should take a "haircut" of 5-10% on bad loans) for the rest of the debt, so that people would owe the government instead of the bank. Then the government could offer generous forebearance on repaying the loan, e.g., a two- or three-year suspension of payments and interest. People who accepted this deal could then be allowed to rent back their homes temporarily at a low rate, with the government reserving the right to terminate this arrangement with six months' notice whenever the state of real estate markets makes resale seem advantageous. This plan would (a) revalue some mortgage-backed securities, (b) ease the liquidity situation of people who can't pay their mortgages while punishing them in the medium run, and (c) destroy some of the housing stock, in effect, since homeowners-turned-renters would lose the incentive to maintain/improve the homes they live in. Effect (c) is desirable because it would help bring housing prices back up.
The above paragraph is just an example, and there may be problems with it, economically, legally, and/or administratively. My point is, though, that we should brainstorm creative fixes, but Congress shouldn't pass anything it doesn't understand-- and even Paulson probably doesn't clearly understand the Paulson plan-- just because they're hearing doomsday scenarios. Shock therapy may be preferable to a cancerous fusion of Washington and Wall Street.
And Steve Landsburg explains why a Great Depression is unlikely:
In the 1930s, a wave of bank failures did make it hard for borrowers and lenders to find each other, and the consequences were drastic. But times have changed in at least two relevant ways. First, the disaster of the 1930s was caused not just by bank failures, but by a 30% contraction of the money supply, which is something today's Fed can easily prevent.
One more thing: the IMF's been a bit underemployed lately, to the point of having to lay off a lot of staff. We could probably hire a large share of the institutional capacity of the IMF for the duration of this crisis for a couple of hundred million. Million-- note the "m." They have experience with this kind of thing-- see the swift return of the pronounced-dead Asian boom. I have a suspicion they'd do as well as Paulson. At any rate, we could get a second opinion.
(Just my luck: the moment I decide to stop political blogging, an economic-political issue explodes that makes it impossible to blog economics without it having political ramifications. Still, I've steered clear of partisan politics.)