A Deficit of Leadership

The financial crisis being felt around the world will get worse - unless strong actions are taken by governments. The strongest action of all is required in the United States, where this global maelstrom originates.

Part of America's economic problem today is a crisis in confidence - in its central bank, the Federal Reserve, in the regulators, in the Bush administration, in the political process. The way the crisis arose, and the way it has been handled, has provided ample reason for that lack of confidence. Bravado statements that everything is fine, followed by unprecedented and non-transparent bailouts and precipitous decreases in interest rates, has led to confidence in the Fed and the administration plummeting, as has confidence in America's banks and their ability to manage risk.

The admission by Bush's treasury that there is a need for regulation may at first seem refreshing, coming after steadfast insistence that these markets are self-regulating and must not be tampered with. But the fact that a core feature of the plan is to give the Fed -- the very agency responsible for many of these problems -- more oversight is hardly reassuring. It didn't use what -powers it had to prevent the crisis; what -assurance is there that with more -"oversight" it will do any better?

Underlying the US's financial woes are three distinct but related problems. First, a debt crisis, exemplified by sub-prime mortgages, with millions of Americans with mortgages greater than the value of their house.

Second, with so many bad debts, and such uncertainty about their magnitude, there is a credit crunch. Banks don't even know the extent of their own problems; how then can they have much confidence in lending to others? It is not, however, just a problem of -illiquidity; it is deeper than that -- -balance sheets have been badly hurt, and will have to somehow be repaired.

The third problem is macro-economic. The US has been sustained by a housing bubble, leading to a consumer binge. Household savings rates have fallen to zero. The Iraq war - and the soaring oil prices accompanying it - has depressed the economy. Money spent on oil or on Nepalese contractors in Iraq is money that isn't being spent at home; these dollars don't provide much stimulation for the economy.

The Fed let forth a flood of liquidity, and the regulators looked the other way as bad loans were made and debt became excessive. In a sense, it had to, if the economy was to keep going, if the costs of the war were to remain hidden, if Americans were to be persuaded they could have a war for free. Hundreds of billions of dollars in mortgage equity withdrawals offset the war's adverse effects. But that game is over. The only reason things aren't worse is that the US has exported its problems, just as it did its toxic mortgages. The falling dollar has helped US exports but hurt other countries' exports to the US. It is the 21st-century version of the "beggar thy neighbor" policies that predominated in the Depression.

Dealing with the crisis demands a multi-faceted approach. At the -bottom, we need to help homeowners stay in their homes. Generous help is given to rich Americans -- through tax deductions, government absorbs up to 50% of the cost of owning a home for those in the upper-income bracket. But it provides little assistance to poor Americans striving to buy homes. Many of the foreclosures are concentrated in particular neighborhoods; public programmes are needed to prevent that blight from spreading and deepening.

At the other end, government rescues will be necessary, as witnessed in Bear Stearns or Northern Rock. But they have to be done better. The US government didn't charge a dime in insurance premiums, and yet Bear Sterns shareholders are walking away with more than a quarter of a billion dollars. It is outrageous for the government to say it is worried about moral hazard when it comes to poor homeowners, many of whom were taken advantage of by predatory lenders and are losing not only their houses but their life savings - and yet somehow to be unconcerned when it comes to the investment banks. Investment banks have prided themselves on their ability to manage risk. The global regulatory framework was premised on that ability. They did manage risk, but in a way that ensured that they were the winners and everyone else the losers. Now everyone else will have to pick up the pieces.

We should be clear, however, that monetary policy and these last-minute rescues can only prevent a meltdown of the economy; it can't resuscitate it. As Keynes pointed out, it's like pushing on a string - and even more so in this era of globalization. With housing prices falling, new liquidity won't make -homeowners borrow more - or banks lend more. The money will look for safer and higher returns elsewhere, like China, which is now worried about US irresponsibility showing up in asset -bubbles in its own economy.

Even the Fed recognizes there is a need for fiscal policy. But what is needed is not the kind of stimulus that has been passed to date - too little, too late, and badly designed. With soaring deficits likely to hit a new record it's important to maximize the amount of stimulus for each dollar of spending. Election-year politics may force the administration to do something, or at least not to stand in the way of Congress doing something.

Given where we are, the downturn is likely to be the worst in at least the last quarter century, probably since the Depression. But the US has more than just a trade and fiscal deficit; it has a leadership deficit. The result is likely to be a downturn longer and deeper than need be. And the whole world will suffer.