Downside Risk

Something that keeps me up at night is the fact that not only is the central tendency in most projections of the US economic outlook pretty bleak, the quantity of downside risk in less likely scenarios remains gigantic. This has a lot to do with political issues.

For example, Representative Brad Miller mentioned yesterday that there’s no way Congress would appropriate more funds for a new TARP-style bank bailout even though the last round of bank bailouts ended up costing less than zero dollars. That means that if things get bad and big banks go insolvent, there’s a very good chance of things going really badly and massive bank failures paralyzing the real economy. A run on money market funds could make it impossible for firms to make payroll, which in turn will leave households temporarily insolvent, etc. And it’s not as if the anti-TARP political dynamic is pointing in a “no new bank bailouts but I’d appropriate $700 billion for some other purpose instead.” If the economy hits a major pothole, then we’re going to be left with Fed open market operations as the only politically workable countermeasure.

Alternatively, you can look at Europe where additional stresses on “periphery” countries could lead to nations exiting the Euro which would also imply bank failures and massive capital flight. Here, too, the problem could in principle be addressed by the stronger European countries doling out massive fiscal aid to Ireland, Spain, etc. but the political odds of this happening are basically zero.

In the most likely scenario, neither of these crises occur. But their occurrence is far from impossible, and the odds are overwhelming that if they arise policymakers won’t rise to the challenge.