Editor's Note: This "Sustainable Developments" column will be printed in the December 2008 issue of Scientific American.

The origin of the U.S. financial crisis is that commercial banks and investment banks lent vast sums—trillions of dollars—for housing purchases and consumer loans to borrowers ill-equipped to repay. The easy lending pushed up housing prices around the U.S., which then ratcheted still higher when speculators bought houses on the expectation of yet further price increases. When the easy lending slowed and then stopped during 2006-07, the housing prices peaked and began to fall. The housing boom began to unravel and now threatens an economy-wide bust.

The U.S. economy faces four cascading threats: First, the sharp decline in consumer spending on houses, autos and other durables, following the sharp decline in lending to households, will cause a recession as construction of new houses and production of consumer durables nosedive. Second, many homeowners will default on their mortgage payments and consumer loans, especially as house values fall below the mortgage values. Third, the banking sector will cut back sharply on its lending in line with the fall in its capital following the write-off of bad mortgage and consumer loans. Those capital losses will push still more financial institutions into bankruptcy or forced mergers with stronger banks. Fourth, the retrenchment of lending now threatens even the shortest-term loans, which banks and other institutions lend to each other for working capital. Interbank loans and other commercial paper are extremely hard to place.

The gravest risks to the economy come back to front. The fourth threat is by far the worst. If the short-term commercial paper and money markets were to break down, the economy could go into a severe collapse because solvent and profitable businesses would be unable to attract working capital. Unemployment, now at 6 percent of the labor force, could soar to more than 10 percent. That kind of liquidity collapse was the basic reason why Asian national incomes declined by around 10 percent between 1997 and 1998, and why the U.S. economy fell by around 25 percent during the Great Depression.

The third threat, the serious impairment of bank capital as banks write off their bad loans, could cause a severe recession, but not a depression. Unemployment might rise, for example, up to 10 percent, which would create enormous social hardships. The ongoing fall in bank capital as the housing boom turns to bust is already forcing banks to cut back their outstanding loans significantly, because they must keep the lending in proportion to their now-shrunken capital base. Major investment projects, such as acquisition of new buildings and major machinery, are being scaled back. Some major nonfinancial companies will likely go bankrupt as well.

The second threat, the financial distress of homeowners, will certainly be painful for millions of households, especially the ones that borrowed heavily in recent years. Many will lose their homes; some will be pushed into bankruptcy. Some may see their credit terms eased in renegotiations with their banks. Consumers as a group will start to become net savers again after years of heavy net borrowing. That trend will not be bad in the long term but will be painful in the short run.

The first threat, the cutback in sales of housing and other consumer durables, is the Humpty-Dumpty of the economy that cannot be put back together. The inventory of unsold homes is now large; housing demand and new construction will be low for many years. Consumer spending on appliances and autos is also plummeting. All these consequences are largely unavoidable and will force the U.S. into at least a modest recession, with unemployment likely to rise temporarily to perhaps 8 percent.

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The goal of any new policy cannot be to prevent a recession. It's too late to stop such a downturn. The goal cannot be to save every bank. The U.S. economy has built up too many imbalances—consumer debt, overextended construction, impaired capital of banks—to avoid an economic downturn and a major retrenchment of the banking sector. The goal must be to avoid an outright collapse or deep recession. Two actions are therefore critical, and two more are subsidiary but still important.

Most important, the government and Federal Reserve Board must prevent the collapse of working capital by supplying short-term loans and taking other measures to sustain the commercial paper market, interbank lending and the smooth functioning of money market funds. They have the instruments to do so, and should use them aggressively. The government should also aggressively promote a recapitalization of the banking system so that bank lending is not squeezed for years to come. It can directly inject some public capital into banks, and can both pressure and entice the banks to raise additional private capital. Unfortunately, the $700-billion bailout nearing approval in Congress does not focus adequately on those liquidity or recapitalization challenges.
The legislation is better than nothing (to help forestall panic) but the real work of stabilizing and recapitalizing the banking system will now await the next administration, and the Federal Reserve will need to stay aggressive in preventing a liquidity collapse."

Two additional steps will be useful. The first will be to ease the repayment terms on existing mortgage holders, to reduce the flood of defaults and foreclosures that will otherwise occur. The second is to encourage expansionary monetary and fiscal policies abroad (most notably in cash-rich Asia), so that the decline in U.S. consumer spending is smoothly offset by a rise in spending in other countries. This overseas expansion would allow the U.S. to offset the fall in housing construction by a rise in exports, and would allow other countries to offset the fall in their exports to the U.S. by a rise in their internal demand. All these steps will have to await the next administration.