There is now little doubt ...

This is the biggest financial crisis since the depression:

The stock market is way down (graph from Calculated Risk). And, as we all know, home prices are also down.

Doubts remain about the health of key financial institutions -- in large part because they extended a lot of credit against homes and kept far more of that credit on their balance sheets than most analysts expected (and certainly seem to have been more exposed than their regulators realized).

Many emerging economies that previously borrowed a lot now cannot borrow. They will have to cut back. That includes previously high-flying emerging economies like Dubai.

Unsold goods are piling up outside US ports. Expensive ones too. Deflation has replaced inflation as a concern.

Economic activity is slowing globally -- and the risk is that will slow more.

Let me give credit to Dr. Roubini (my former boss) for holding firm to his conviction that vulnerabilities were building even as it seemed, at least for a while, that the US economy would be able to shrug off a fall in investment in new homes.

The key challenge now is to guard against the risk that the current financial crisis will morph into a deep and sustained fall in economic output. Dr. Krugman mentioned a recent Goldman Sachs report (GS US Economics Analyst November 14 2008) on the US economy. I’ll plug it too. Goldman Sachs forecasts that the private sector’s financial balance -- private borrowing net of private investment -- will swing from a deficit of 4% of GDP in 2005 to a surplus of around 10% of GDP at the end of 2009. That means that the US private sector will go from being a net borrower to a big net saver.

The overall swing is far larger than the swing from a deficit of around 6% of GDP to rough balance that accompanied the .com crash. That makes sense. The .com crash wasn’t accompanied by a large fall in home prices -- and didn’t trigger a banking crisis.

Moreover, the process has a long way to go. The private sector balance has gone from a 4% of GDP deficit in late 05/ early 06 to a surplus of around 1% of GDP in the second quarter of 2008. As a result of this fall in the private sector’s net borrowing, the US current account balance improved even though US government borrowing has gone up. But if Goldman’s forecast is right, the swing in the private sector’s balance is only about one-third over -- and the improvement in the private sector’s financial balance will be a large drain on economic activity for the next year.

What to do? Goldman (Hatzius, McKelvey, Philips, Tilton, Smyth, Michels and Sum) recommend:

a) A substantial fiscal stimulus (they suggest that a $300-500 billion/ 2-3% of GDP stimulus might not be enough)

b) Aggressive GSE lending. Goldman observes that the GSEs have cut back on their lending (really lending that they support through their purchases of mortgages) since the September "Agency" crisis -- something that feeds into further falls in home prices. Agency spreads remain wide.

c) The Fed could pre-commit to keep policy rates low for a long time

d) The Fed could start to buy long-term assets -- starting with Treasuries, and then moving toward more risky assets -- to bring long-term rates down, and generally start to deploy their less conventional policy options.

Goldman believes that the first three steps should be adopted now -- and the last step should be held in reserve. That makes sense to me. I would add policy efforts to try to limit the fall in demand for US and European goods from emerging economies to Goldman’s list of near term policies. I worry a bit that the US will do too much of the heavy lifting to support global demand and emerging economies with large surpluses will do too little, helping to sustain a larger external deficit than I would like. But right now even I would argue that concerns about the path of external adjustment need to be subordinated to guarding against the risk of an enormous fall in US demand. Goldman’s analysis offers a good starting point for debating how best to try to contain the economic fallout from the current financial turmoil.