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There is a pervasive sense of unreality in Washington about the nature and scale of the economic crisis facing the United States and the world. The Obama Administration seems to be proceeding on the assumption that the problem in the US financial sector is still one of illiquidity rather than insolvency, and that the task is to prop up US banks for the next few months until markets value their toxic assets more fairly. The growing consensus of many economists, on the other hand, is that they are insolvent. The rapid downturn in the real economy, accelerated by the financial meltdown last fall, is feeding back into the banking sector as higher quality home mortgages (like Alt-As), commercial real estate loans, and credit card debt start to go bad. It is easy to see why the administration doesn’t want to admit to itself that the banks are insolvent, because this would mean going back to Congress for another trillion or so dollars for further bailouts. It is this political logic that kept Japan from dealing with its non-performing loan problem in the 1990s, and means we may be headed down the same road.
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