U.S. Financial Crisis Escalates to Dangerous Levels

The initial conditions in the economy and the financial markets prior to the bankruptcy were already extremely weak. The economy was losing momentum—industrial production is expected to decline sharply in the third quarter (for the second consecutive quarter) consumption spending will likely contract, and the unemployment rate is ramping up sharply. Perhaps even more troubling, credit conditions continued to tighten in the summer months, and the growth of credit has slowed down to recessionary levels.

The bankruptcy of Lehman Brothers will put further deflationary pressure on financial markets and the economy at a time when such pressure can be ill-afforded. While the large loan program announced by major global banks today may help ease the shock, we should not delude ourselves into thinking that without a significant move from the Fed there will not be further tightening of credit conditions as a result of the events over the weekend. That will threaten the U.S. economy and the financial system even further.

The downward pressure on asset prices likely to flow from the bankruptcy also puts other major financial institutions at risk—and we need not name names here. Suffice to say that further bankruptcies of major financial institutions would be a process that the economy cannot support at this particularly fragile juncture of the business cycle, and we would be looking at further severe deflationary pressure if indeed this does happen. Under this destabilizing scenario, Congress would come under incredible pressure to craft another fiscal-stimulus plan, and there is also a strong likelihood it would need to step in and capitalize a major government financial entity that would purchase distressed financial system assets, along the lines of the Resolution Trust Corporation—both outcomes of course at massive taxpayers' expense.

The economy is very weak, the recession wolves are pounding down the door, and the financial system faces new deflationary threats from the bankruptcy of Lehman Brothers. This is an emergency situation and an aggressive response from the Fed is needed.

Without such a response, pressure on Congress to take further action to stem the crisis would be unstoppable. In this case, the cost to taxpayers will escalate massively and burden American households with additional government debt for years to come.