Making sense of the financial market meltdown

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Editor’s note: Virginia Business turned to J. Alfred Broaddus Jr. for answers during recent upheaval in financial markets. He was president of the Federal Reserve Bank of Richmond from 1993 until 2004, serving as a rotating member of the Federal Reserve System’s Open Market Committee. As this issue went to press, federal officials were hammering out a plan to rescue banks from bad debt.

Some have said this is the worst financial crisis since the Great Depression. Is that a fair comparison?
It’s too early to reach that conclusion.  There has obviously been a historic transformation of Wall Street with the demise of some of the country’s biggest and most prestigious financial companies, and there is real pain.  But the assets and many of the jobs of some of these companies, like Merrill Lynch, are being at least partly preserved by mergers.  In the Depression, many investment houses and large and small banks simply disappeared.  And the negative impact of the financial meltdown on the broader economy in the Depression drove the unemployment rate up to nearly 25 percent.  Unemployment has risen lately, but not nearly as sharply. 

Can the U.S. economy withstand the collapse of more giant financial institutions?

Yes. Setting the present financial turmoil aside for a moment, the broader American economy is still huge, extraordinarily innovative and productive — the economic wonder of the world.  As long as we stick to the fundamental principles that have made it so — an open and competitive economy governed by the rule of law — our longer-term economic future is secure and bright.  Further near-term problems in large financial institutions, however, could make the next few months and possibly the next few years pretty turbulent economically, with more job losses and other economic pressures on the average household. 

How will the financial turmoil affect people and businesses in Virginia?
Many Virginia businesses and households have invested in the stocks, bonds and other financial instruments that have lost substantial value during the crisis.  This will make lenders more careful in making new loans and investing in new projects, which will likely slow overall economic growth in the Commonwealth for a time and probably lead to some job losses. Virginia’s economy, however, is more diversified than many other state economies, and it enjoys a significant federal government presence and the generally stable jobs that go with it.  So the Commonwealth should feel a smaller negative impact than many other states and regions such as the New York metropolitan area, where much of the U.S. financial industry now under pressure is centered. 

Will these events make recession inevitable?
They certainly make it more likely, and we may well be in one already.  The main channel through which the financial crisis affects the broader economy is the so-called credit channel. The crisis has spread fear among lenders, including not only banks and other financial institutions but also ordinary households that effectively lend to private companies by purchasing mutual funds that include corporate debt securities. Credit is now expensive for private borrowers if it’s available at all. Credit plays the role in the economy that the bloodstream plays in the human body. When the flow of credit is slowed or interrupted, the economy slows with it. 

How long do you think it will take for the economy to recover?
One question might be: How long will it take for the crisis to end?  No one knows for sure.  The main thing that needs to happen before it can end is that the permanently impaired — i.e., “bad” — assets now sitting on balance sheets around the country need to be recognized and written down. In other words, the losses must be absorbed so that we can move on. This healing process is already in motion, and it could be accelerated to some degree if the government creates a workout agency like the Resolution Trust Corp. of the savings and loan crisis. This doesn’t answer the question of how long but hopefully helps clarify the underlying conditions that will determine how long. 

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