German Chancellor Angela Merkel, speaking in the German Bundestag on Wednesday, Nov 26,2008.

Angela Merkel, the German chancellor, on Wednesday accused the US and other governments of making “cheap money” a central tool of their economic management, thereby planting the seeds of a similar crisis in five years.  Meanwhile, Morgan Stanley said aggressive policy actions will avert both depression and deflation.

“Excessively cheap money in the US was a driver of today’s crisis,” she told the German Bundestag. “I am deeply concerned about whether we are now reinforcing this trend through measures being adopted in the US and elsewhere and whether we could find ourselves in five years facing the exact same crisis.”

Morgan Stanley economist Richard Berner says three lessons for policymakers from the Depression and Japan stand out: First, aggressively use macro policies to buy time for other needed policies to be implemented and to take effect.  Second, employ policies to stabilize the financial system and attack the roots of the credit crunch.  Finally, adopt measures to reduce the imbalances, especially in housing, that triggered the downturn. 

Berner says macro policies must be forceful and appropriate to cushion the blow from the adverse feedback loops depressing markets and the economy and to avert deflation.  How forceful? He says, consider that the free fall in global equity prices and the decline in home prices will have slashed US household net worth by $11 trillion or nearly 20% over the course of 2008.  Even if asset prices somehow stabilize by year-end, this unprecedented plunge in household wealth may prompt consumers to cut spending by a cumulative four percentage points next year and in coming years.  Tighter lending standards for businesses, residential and commercial real estate, state and local governments and a weakening global economy seem likely to depress demand by roughly another 2 percentage points of GDP over the coming year.  While the sharp slide in gasoline and other energy quotes will add back $250 billion or more (2-2.5%) to discretionary incomes, that still leaves a hole of roughly 3-4% of GDP ($425-575 billion) to fill.  If no lame-duck plan (before President Obama is sworn-in on Jan 20th) is enacted (other than extending unemployment insurance benefits), then the incoming Obama Administration is right to consider a very substantial menu of fiscal stimulus including immediate, medium-term and longer-term elements.

Morgan Stanley says further aggressive steps for monetary policy to avert such an outcome are appropriate, but with the Federal funds rate at 1%, many perceive that the Fed is running out of ammunition. 

MS doesn't accept this view and it says that the Fed has already begun an aggressive plan of quantitative easing (QE) that has doubled the size of its balance sheet in two months.  The problem, of course, is that banks are hoarding the resulting expansion of reserves.  As a result, QE has had little impact on expansion of bank balance sheets or on the economy; in effect, the money multiplier (the ratio of monetary aggregates or bank liabilities to bank reserves) has collapsed. 

Richard Berner says three additional policy options are available to realize the full potency of QE, ease financial conditions, and help revive securitization markets.  First, the Fed can buy longer-term government securities or private sector securities such as mortgages.  That would bring down longer-term yields and more importantly the wider risk spreads that are symptomatic of dysfunctional securitization markets and that have made financial conditions ever more restrictive.  Second, the Fed can commit to keep the funds rate rates low. Finally, the Fed can monetize the coming fiscal stimulus, keeping rates low despite significant actions that would boost the demand for credit and otherwise push rates up. 

Berner says using available funds to inject capital in exchange for preferred shares, and creating a mechanism – a “good-bank-bad bank” structure – to ring-fence some troubled assets , promote appropriate writedowns, and encourage significant further consolidation in financial services.  In turn, cleaning up balance sheets, as was ultimately done in Sweden in their 1992 banking crisis, in Japan, and in the US savings and loan crisis, will help slow the deleveraging process and ultimately is the only way to end the credit crunch. 

The second needed set of policies includes aggressive implementation of steps to mitigate mortgage foreclosures.  The rising tide of foreclosures adds to the inventory of vacant homes and to the real estate owned on lenders’ balance sheets, puts downward pressure on home prices, and creates significant economic hardship for the individuals, the lenders, and the communities involved. 

Finally, Berner says officials should seek policies to reduce the supply-demand imbalance in housing.  Here there is debate over the most effective policy options.  New tax subsidies, as proposed by US economist Alan Meltzer, would increase housing demand, but they risk becoming permanent.  And in the context of a serious credit crunch, they may not be sufficient to push up housing demand.  It’s worth noting that the benefits for housing demand from lower mortgage interest rates and increased credit availability from steps 1 & 2 above should also help.  In other words, these three steps should be implemented in concert as part of a complete package.