Resident Fellow Desmond Lachman

At this stage in the economic downturn, it would seem clear that there are two primary forces driving the global economy downwards and giving rise to a series of adverse feedback loops. The first is a vicious process of asset price deflation as exemplified by the more than 20 per cent decline over the past year in US home, equity, and bond prices. This process, which is far from over, has already reduced US household wealth by the equivalent of around 80 percentage points of US GDP. As such, it must be expected to materially impact household consumption expenditure and complicate the banking sector's loan loss problem.

The second force bearing down on the global economy is a virulent process of financial market de-leveraging that is now not simply confined to the banks but that is also engulfing the hedge funds, which are presently experiencing the equivalent of a bank run due to poor performance. As a result, US bank credit is contracting at its fastest pace in the post-war period while the all important securitisation market is in a virtual state of paralysis.

With a deep global recession now all but a certainty, Martin Wolf is correct in asserting that the time for a higgledy-piggledy, institution-by-institution, country-by-country approach is long over. However, it would seem at least in the United States that policy needs to go considerably beyond adequately recapitalizing the banks if the economic recession is not to morph into something even nastier. At a minimum, it would seem that major government intervention is needed to stabilize housing prices and arrest the alarming rate of foreclosure that threaten to further add to bank loan losses. Simultaneously, it would seem that one needs both a second fiscal stimulus package and yet more monetary policy easing to stimulate domestic demand.

Desmond Lachman is a resident fellow at AEI.