Tuesday, December 23, 2008


Last week the Federal Reserve made history by lowering its benchmark lending rate to a range of zero to 0.25%. It has now entered the zero interest rate territory (the “zero bound”) that Japan confronted in its own long (and largely unsuccessful) fight against deflation. Of even greater significance, the Fed announced that it would, essentially, print as much money as necessary to unthaw the credit markets and revive the economy.

In 2002, Fed chairman Ben Bernanke (before he became Fed chairman) gave a (now famous)
speech on the subject of deflation (it’s worth reading if you are a real economics junkie). Bernanke concluded that the government could always combat deflation simply by printing more money. He made reference to Milton Friedman’s famous “helicopter drop” phrase which evokes the image of a central banker using a helicopter to rain money down upon the economy (giving rise Bernanke’s unfair but prescient nickname, “Helicopter Ben”). As a practical matter, the Fed doesn’t use a helicopter. Rather, as Bernanke noted in his speech, “If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.” If it could get around legal limitations on its ability to directly purchase private assets, the Fed could cut out the Treasury as a middle man and purchase the private financial assets itself to directly inject money into the economy. That is what the Fed is now proposing to do. As the Fed said last week, “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth.” Those tools include buying “large quantities” of mortgage-related bonds, longer-term Treasury bonds, corporate debt and even consumer loans.

In a little noted (but huge) development, the Fed said it would
lend up to $200 billion to hedge funds to allow them to purchase asset-backed securities comprised of credit card receivables, automobile loans and student loans. This is the first time the Fed has ever lent to private unregulated investment funds. It may also be a disguised attempt to slow down hedge funds redemptions (disguised because it would cause political outrage if the Fed were to overtly bail out hedge funds). I don’t see any other reason why the Fed would lend money (let’s say at 1 or 2%) to hedge funds to allow them to buy consumer debt that generates much higher yields (say, 5 or 6%). Why wouldn’t the Fed just buy the asset-backed securities directly? What value do the hedge funds add?

It is reasonable to assume that they are sweating bullets at the Fed. It has essentially exhausted traditional monetary policy and is stepping in as a substitute for banks and other lenders and acting more like a bank itself. Make no mistake about it; we are now in “helicopter drop” territory.

When nominal interest rates reach zero, the economy risks entering a “
liquidity trap.” In a liquidity trap, financial assets become unattractive and people and firms prefer to hoard cash. In that environment even banks are unwilling to lend, preferring to use any increase in funds to boost their capital, with the result that any increase in liquidity by the central bank gets “trapped” behind unwilling lenders. That is exactly what is happening now and it is a central banker’s worst nightmare.

In the simplest Econ 101 formulation, Total Income = Money times Velocity (i.e., the turnover of money). This is a truism. If Velocity drops faster than the Money supply increases, nominal Income will drop. That can take the form of deflation or a drop in real income or some combination of the two. A “liquidity trap” can be viewed as a precipitous drop in Velocity.

You don’t have to look far for indications that the threat of deflation is real.

The Consumer Price Index fell 1.7 percent in November, the steepest monthly drop since the government began tracking prices in 1947.

In recent weeks, the
yield on three-month Treasury bills actually went negative during a brief period of intra-day trading Investors were willing to pay the government to keep their money safe for a few months. It is the modern equivalent of keeping your money in your mattress. (Warren Buffett quipped: “This should be bullish for Berkshire. With great foresight, I long ago entered the mattress business in a big way through our furniture operation. Now mattresses have become fully competitive as a place to put your money, and sales will soon take off.”)

Even more alarming, however, was the
yield on 30-year Treasury bonds. Yesterday it stood at 2.59%. How fearful do investors have to be to lock up their money for 30 years at 2.6%? There is some significant element of the investor population out there that believes we are in for a Japanese-style deflation (or worse) for at least a couple of decades. I’m not in that camp (yet). But we damned well better be taking that prospect seriously and temporarily put aside political agendas like trying to crush the UAW in favor things like trying to preserve the largest consumers of steel, plastics, glass and electronics in the country (i.e., the US auto industry).

The Commerce Department
reported today that home sales dropped 8.6% in November. And the National Association of Realtors estimated that 45 percent of all home sales in November were so-called “distressed sales,” meaning that the sellers faced foreclosure, or they were forced to sell their home for less than the value of the mortgage. The median home price is now down 21% from its peak in July 2006.

Another indication of deflationary expectations: The price of oil
dropped on Friday to just over $33/barrel (it subsequently rebounded in response to news that OPEC committed to reducing daily oil output by a further 2.2 million/barrels a day – bringing the cuts since September to 4.2 million/barrels a day,or 5% of daily global output). You might recall the price of oil reached a peak of $147/barrel as recently as July. Certainly there was a large speculative element to that July price (excess global liquidity seeking refuge in one last bubble, commodities). But the subsequent decline in the price also reflects real pessimism over the near-term prospects of the “real” economy and its life blood, oil. (Let’s hope President Obama can set us on the path away from dependence on that vile substance.) Someone is expecting a whole lot less economic activity than previously thought.

(One positive aspect of the decline in oil prices: Prospects for the Obama administration to achieve some kind of “Grand Bargain” with Iran – including Iraq, Israel and their nuclear program – are probably as good as they have ever been. At least as good as they were when
Iran proposed just such a Grand Bargain in 2003 only to have the Bush administration fail even to respond to their overture. The Iranian economy is in horrible shape and could benefit from a thawing of relations with the West.)

Fortunately, we have a new president and a new economic team about to arrive that understands the urgency of a major fiscal stimulus. At a news conference last Tuesday, president-elect Obama said, “We are running out of the traditional ammunition that’s used in a recession, which is to lower interest rates. It is critical that the other branches of government step up, and that’s why the economic recovery plan is so essential.” And that plan is growing with every passing week. During the campaign Obama spoke of a two-year fiscal stimulus of $175 billion. As the magnitude of our economic problems set in, that was raised to $600 billion or so. Now Obama’s advisors are talking of a economic recovery plan of $675 to 775 billion, while acknowledging it could go higher. As the New York Times
notes, even Bush’s former top White House economist, Lawrence Lindsay (no liberal), is now urging a $1 trillion stimulus plan. (You might recall Lindsay was forced out of the White House after honestly answering in a Wall Street Journal interview in late 2002 that an Iraq war could end up costing as much as $100 to 200 billion – which wasn’t consistent with the official White House line that we would be greeted with flowers and candy at essentially no cost.)

In his New York Times column yesterday (“
Life Without Bubbles”) Nobel Laureate Paul Krugman (I love writing that) writes of the need for sustained fiscal stimulus:
In short, getting to the point where our economy can thrive without fiscal support may be a difficult, drawn-out process. And as I said, I hope the Obama team understands that.

Right now, with the economy in free fall and everyone terrified of Great Depression 2.0, opponents of a strong federal response are having a hard time finding support. John Boehner, the House Republican leader, has been reduced to using his Web site to seek “credentialed American economists” willing to add their names to a list of
“stimulus spending skeptics.”

But once the economy has perked up a bit, there will be a lot of pressure on the new administration to pull back, to throw away the economy’s crutches. And if the administration gives in to that pressure too soon, the result could be a repeat of the mistake F.D.R. made in 1937 — the year he slashed spending, raised taxes and helped plunge the United States into a serious recession.

The point is that it may take a lot longer than many people think before the U.S. economy is ready to live without bubbles. And until then, the economy is going to need a lot of government help.

Krugman’s essential point is that recovery from the current economic downturn, when it eventually comes, will be qualitatively different than previous recoveries. It will not be fueled by the kind of easy money and debt to which we have grown accustomed.

In his December
Outlook column, PIMCO’s Bill Gross, the country’s best bond fund manager, makes the same point in the investment context, cautioning that we have to adjust our long-term investment perspective,
“ …for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. Recent Investment Outlooks … have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability
to make a deal with other people’s money. …

My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.
Dow 5,000? We don’t have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks. ..” [emphasis in original]

A few months ago, The Onion ran a headline, “
Recession-Plagued Nation Demands New Bubble to Invest In.” Don’t count on it. We’ll be lucky if we avoid major deflation.

1 comment:

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