Dear readers,
We are in the last straight line of what has been a challenging 2009 for every one of us and not only those who have a job in finance. It was an emotional roller coaster where the world crawled through the symbolic eye of the needle in avoiding a depression we only saw back in the 1930s. After that we saw equity markets euphorically rebound from their lows in mid March under the umbrella of massive government worldwide.
Green shoots were added to our vocabulary but we can not shrug off the impression there is a divergence going on between the health of the economy and the state of the stock market. The world is clearly looking for a new equilibrium, and it is obvious it will be at a (much) lower level than we have known earlier this decade.
We admit we underestimated the rebound of the stock market, but we should have known if we had considered the trillions of dollars of liquidity that were poured into the market by governments to keep the financial system afloat. So far our mea culpa of 2009.
Nevertheless we persist in seeing very dark clouds above us. While the stock market is taking a massive advance on economic recovery, the bond market is telling us a completely different story. Yields on short term fixed income paper have been pushed down to almost zero (US T-Bills maturing April 2010 are yielding hardly 7 bps) which forces investors to chase more risky assets or, as Bill Gross of Pimco argued recently “The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks.”
However this almost negative yield level is also indicating that some investors prefer to pay the government to hold their cash in stead of putting their money at work.
It remains the one million dollar question when the Fed and other central banks are going to take back all this liquidity. Maybe from mid 2010 onwards, but it can be (much) later as well. One thing we know already, this will be a painful process for investors. We live at this moment in a very confused environment. On the one hand it is the best of times for investors as central banks offer a “free lunch” to the market, but on the other hand we face the worst of times as the economic fundamentals are still impaired.
One of the major economic challenges will be what will happen in the commercial real estate market. There are some similarities with the residential – subprime market which triggered the Great Credit Crisis of 2007. Back then prices of subprime mortgage bonds, reflected in the ABX Index, were already falling systematically since July 2006. Things deteriorated dramatically over that year and early 2007, HSBC and New Century, two of the major US lenders in that market, gave a first hint they had to make considerable provisions on their mortgage portfolio. It was only at the beginning of August, when two money market funds of BNP Paribas got into trouble, that the distress of the real estate market caught the eye of the public.
Of course, since the beginning of the crisis commercial real estate has been hit hard as well, however there are signs that things are deteriorating. Even the Federal Reserve admits this in its recent Beige Book report.
In the US, year to date there were already 5,772 foreclosures, defaults or bankruptcies representing an amount of $ 123 billion (data: Real Capital Analytics). The major reason is because commercial real estate was highly leveraged, and as a lot of these loans need to be re-financed, the industry is suffering as banks stand on the brakes to continue lending.
To underwrite the statement of Carolyn Maloney, Chairwoman of the Congressional Joint Economic Committee, saying that the commercial real estate market is a ticking time bomb: in the US alone, over $ 2.7 trillion of commercial real estate debt will have to be rolled over in the next 5 years with a peak in 2012 (these numbers do not take into account the additional $ 700 billion – $1.1 trillion of speculative leveraged finance debt). For 2010 between $ 530 and $ 700 billion is due for refinancing (data: Foresight Analytics LLC). According to the FDIC this can bring a total of 700 banks at risk of failure. A disproportionately high number of small and medium-sized banks have sizeable exposure to commercial real estate loans, and delinquency rates at around 7 percent will add further pressure on banks balance sheets that must mark these loans to market.
Financial institutions around the globe are very aware of this next tsunami wave and this is one of the major reasons why banks are so reluctant to lend. The facilities being put in place by central banks are primarily used to restore banks’s balance sheets so as to be robust enough to take the next commercial real estate hit. Lending is only of secondary concern.
Another worrying sign of the commercial real estate situation was the Fed intervention to throw out five commercial market bonds that were pledged as collateral for taxpayer loans to purchase debt earlier in November.
In an effort to clean up bank balance sheets and encourage new lending, the Fed opened its Term Asset-Backed Securities Loan Facility (TALF) to so-called legacy commercial-mortgage bonds. TALF attracts buyers by pumping up returns with low-cost Fed loans. Bonds deemed too risky are rejected. But the latter will limit future appetite for the programme.
All this will continue to weigh as a sword of Damocles on the market in 2010. Will it trigger a huge correction? Maybe, but not necessarily. This is in the hands of the central banks. Only as from the moment they indicate rates will rise again, markets will get nervous.
An interesting report published by the Investment Company Institute, the national association of US investment companies overlooking over $ 11 trillion of assets under management, is showing that cash which was parked on the sideline since the Lehman collapse back in September last year is steadily flowing back to the equity market. Nevertheless the amount that is parked on deposit accounts and money market funds is still well above historical levels.
This teaches us that the stock market remains well supported as any major correction will be used to put money at work. Not because the economic outlook is prosperous, but fund managers are judged by benchmark performances and many of them have missed the rally which took off mid March.
Furthermore the data of the ICI shows especially institutional investors have missed out on the rally, confirming our previous reports that this was a retail driven rally.
This means there is a reasonable possibility that the rally will continue into early 2010, as institutional investors can not afford to remain sidelined.
In the meantime, most probably, we will get further mixed economic data, confirming what John Mauldin still calls a muddle through economy as banks, corporates and consumers continue their deleveraging process.
Around April, when Q1 results come in, it will be a first moment of truth to see whether the preliminary recovery that we have experienced so far is only built upon stockpile adjustments or whether the US consumer shows more resilience. Although considering the fact that Average Joe still needs to bring down its debt ratios and increase it savings it is unlikely that it will come from that side. Therefore any further growth prospects should come from China that continues its path of economic development, on further governmental support.
This brings us to another potential dark cloud, the US government debt. During 2009 the US Treasury had to finance approximately $ 1.8 trillion of debt as a consequence of several bailout packages. For the fiscal year 2010 the White House projects a deficit of roughly $ 1.26 trillion. This is under the assumption that no further bailouts or stimulus packages are needed during next year. Also bear in mind there is another $ 1 trillion to be digested by the bond market for fiscal year 2011 ceteris paribus. (These numbers do not even take into account the additional burden on the US budget due to the new healthcare plans which were approved in Congress earlier this month).This is certainly an environment where the US Treasury can not afford any failed auctions on its bond issuances. Together with a USD which remains under pressure it will be interesting to see how US sovereign debt credit spreads will behave.
There will be no problems at all as long as sovereign wealth funds and other foreign banks continue to buy up US government debt. However from the moment the bond market starts sputtering spreads will widen again. Consider this as a potential black swan event hanging over the market for the next few years with a probability that the market priced at a too low a level the actual risk. This will certainly be a trade where event driven and/or global macro hedge fund managers will continue to look at.
It’s a small step from the US government debt to the USD. Due to the monetary outlook from the Fed, the USD is now used as a borrowing currency in the carry trade, similar to what happened to the JPY over the last 15 years.
We are still waiting for data from the Bank of International Settlements (BIS) to get an idea what the size is of this USD carry trade. Mr. Roubinni earlier this week argued it is 10 times the size of the JPY carry trade. To put this into perspective, according to data from the BIS the total amount of the JPY carry trade was around $ 1.05 trillion!!!
A change in the outlook of US monetary policy will trigger immense volatility in the currency market. In case this happens the borrowed currency starts rising rapidly as every investor involved in the trade has to start buying this currency in order to pay back the loan.
There are several examples of that over the last several years. One to remember was the unwind of the JPY carry trade in September 1999 when the hedge fund LTCM collapsed. In less than a month USDJPY dropped from 122 to almost 100.
Therefore we remain very cautious on recent USD weakness. This can be reverted in a split second, and we consider this one of the major risks of 2010. Even when the current USD carry trade is only twice the amount of the JPY position in 2007, there is a massive systemic risk hanging above the market which can easily push EURUSD towards 1.20 again in a number of weeks. The longer term outlook on the USD however remains very concerning due to the US deficit.
Last but not least the financial state of banks. On both sides of the Atlantic some banks still are in deep trouble but can mask their situation at this moment by a combination of creative accounting and the benefits of a steep yield curve. The head of the IMF, Dominique Stauss-Kahn, expressed similar concerns, arguing that there is a reasonable possibility that 50% of bank losses have not been reported yet, and are hidden in the balance sheets especially among European banks. Only last week the market got shaken up by woes in the Middle East where Dubai World was unable to roll over its debt. Especially major European banks have exposure of up to USD 20 billion to the Emirates state. This is certainly not helpful to the already fragile balance sheets of the financial industry.
If this is a fact 1 of 2 developments could be seen in 2010. Either we might see another wave of nationalisations or, depending on the risk aversion of the markets, banks will have to raise more capital individually. The latter is more likely if we do not return into a Minsky moment like we have seen when AIG and Lehman collapsed during the same week.
To round up cryptically, 2010 will remain a very difficult year, where the cheap funding from central banks act as the Lorelei, one of the Rhine Maidens of the famous Nibelungen song, who rises from the waters trying to lure the ships onto the cliffs with her seductive singing. Despite these temptations it would be wise to keep your ships close to the coast in these stormy weathers.
Friday 4 December 2009
Thursday 5 November 2009
Animal Spirits: lessons to be learned out of the crisis.
Dear readers
Back in June we already wrote about the importance of psychology on issues such as inflation (The Unemployment – Inflation Theme). When inflation is discussed it is only a small step towards asset inflation and asset bubbles more specifically. One of the fuel components of the Great Credit Crisis was obviously the housing bubble. Before that people had only just shrugged off another crisis, that is the dotcom bubble.
Unfortunately in this debate on too many occasions one forgets to mention the responsibility of central banks and certainly that of former US Federal Reserve Chairman, Alan Greenspan who fuelled both bubbles with aggressive monetary policy like the way he handled the LTCM Crisis, Y2K and 9/11 events.
According to the Chairman it was not up to central banks to detect the build up of asset bubbles. The only thing a central bank should do in case of an asset bubble burst was to provide enough liquidity to the banking system in order that it would not collapse. Later on this was named the Greenspan doctrine and is closely related to issues such as lender-of-last-resort and moral hazard.
It is not our intention in this newsletter to overload Mr. Greenspan with all the sins of Israel, but do think that central banks should spend more time in studying asset price developments and should search for bubbles which could potentially wreck a (global) economy.
By trying to fix this problem we will have to look at how central banks and (investment) banks have been operating over the last 3-4 decades. Certainly since the Greenspan era there was this blind believe in the “Invisible Hand” and the Efficient Market Theory. There was this dogmatic conviction that the market was always right and would solve any problem. Putting this into doubt brings us on a collision course with one of the greatest economic thinkers of the 20th century Milton Friedman and his Chicago School.
We do not want to throw the free market principle over board. We are still strongly convinced that this has been the best socio-economic model in creating wealth. We all know by now what the credentials were of a state planned economy. So we will not touch this part of the discussion.
More importantly is to go to the core of the assumptions which are being made by the Efficient Market Theory and monetarists such as Milton Friedman. All of these theories start from the hypothesis that all market participants act rationally. Even Mr. Friedman knew that everybody has its individual preferences, but the concept of Homo Economicus, was so tempting as abstraction and strategic simplification, is the only way we can impose some intellectual order on the complexity of economic life.
This reasoning was the corner stone to theories such as the idea Mr. Friedman always taught us that employees and employers remain rational when negotiating on wages or deciding on investments and taking inflation into account this in an undiluted way.
But if this is true, bubbles could not exist. The Efficient Market Theory is also claiming that all information is priced into the market at any time and today’s price is the best indicator for the price of tomorrow. Furthermore the market always finds a balance between buyers and sellers at the right price. This equilibrium can only be disturbed due to a shock in the supply and demand chain, like for example the oil shock we have known in the 1970s. The thought of a previous price increase would lead to another is simply impossible to these classical economists.
However, how can one explain that from one day to another prices collapse? We all have seen the charts of stocks or real estate that fell of a cliff. Conventional economists have no explanation to this either. Even one of its greatest supporters, Alan Greenspan himself, admitted in 2008 he was spooked by this thought.
Behavioral economists may have the answer to this. They have done extensive research around the concept of “the illusion of money”. During a bubble build up it became obvious that investors are selectively ignoring obvious data and their behavior distorts price developments which inflates the price of the underlying asset. Dr. Robert Shiller, one of the great researchers on behavioral finance, applied this to the housing market and described it as follows: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.” (1)
First of all this comes close to experiences that most of us must have had in the past when trading or investing, in for example stocks. We can call it the state of denial where an investment is going against you, and one refuses to cut your losses. The self fulfilling prophecy in believing that a position will come back to its initial level and hopefully goes back above it. Information is selectively read and analysed and other data pointing to a justification of the correction is ignored.
This to us is already a first sign of the presence of irrational participants in financial markets.
Another lesson that we should have learned already long before the outbreak of the Great Credit Crisis is that markets are more driven by mutual trust than pure rational decision taking. One can detect this easily in the functioning of emerging markets where spreads are much wider compared to developed markets. The spread is the reflexion of available liquidity which can simply be brought back to trust as well. It is because not a lot of people are confident putting their savings at work in let’s say a country like Kazakhstan (just to name one) that it is difficult to find an equilibrium between a buyer and a seller.
This is only an emotional perception, which can easily trigger anxiety and can quickly turn into outright panic. This is what ultimately causes a collapse of prices, what we have seen on many occasions in the past. How many of us didn’t own stocks during the dotcom bubble which decimated overnight? All of us are driven by this illusion of money. It is the failure of this money illusion to account for inflation that will lead to emotion driven investment decisions with painful outcomes at the end of the process.
This is also what happened in the real estate market. Lenders had huge trust in economic data that over the past 70-80 years real estate prices never dropped on average on a national scale. They did not take into account that for example a rise in interest rates would have devastating effects on the repayment capacities of a large number of borrowers. This would lead to foreclosures and would negatively affect the value of houses. Unfortunately when the Federal Reserve started rising rates rapidly from 2003 onwards real estate prices did come under pressure.
Finally it does not take a neurologist or Sigmund Freud to know that there is a huge difference between starting from scratch and making EUR 2 million or having EUR 10 million and losing EUR 8 million but ending up with the same EUR 2 million. For our Homo Economicus, who behaves rationally, it would not make any difference. Unfortunately socio economic pressures around us indicate it makes a massive difference!
Neuroscientists have identified the source of this problem and it is located in the cortex of the brain. People who experienced a car accident with severe head injuries or even patients suffering from autism apparently do not have problems with a balancing exercise of gains versus losses. In both cases a malfunctioning of the ventromedial prefrontal cortex (VMPFC) is to blame. This does not mean that we should put the whole investment world on drugs which would switch out our VMPFC functioning in order to avoid bubbles in the future.
A more useful tool would be the model developed by a group of researchers at MIT which is known by the name “the Adaptive Market Hypothesis” (AMH). The framework they worked out is based upon the evolutionary theory and tries to predict increased volatility among investors. Basically it comes down to measuring the correlation between price changes that took place on a certain trading day and the influence of this on the price change the day after. (2)
This goes against the Efficient Market Theory that argues that price changes are randomly generated in time. However during the build up of a bubble they will identify high correlation, indicating that investors are showing herding behaviour and vice versa. The approach does not throw away the Efficient Market Theory as they recognize that markets can be in an efficient or rational mode but at times it can turn inefficient or irrational. After a bubble has burst the market can return into a more rational condition where investors’ view on the direction of the market is not influenced by each other. But during a bubble build up investors decisions will be highly correlated. We recognize this from street talk such as the TINA-hype (there-is-no-alternative) during the dotcom area and the subprime cycle.
If this AMH model proves to be reliable, it could be used as a tool by central banks to determine their monetary policy. This does not imply that a central bank should immediately start hiking rates when it detects a bubble but as a regulator it can start adjusting certain anomalies in the industry via legislation or rhetoric.
The AMH has also another advantage. It would help explaining why certain trading strategies are successful in certain specific markets. This would increase the performance of funds.
Now we are dealing with the aftermath of the Great Credit Crisis a debate should be started to revise the Efficient Market Theory and the unlimited trust in strength of “the invisible hand” of financial markets. Not only behavioural scientists have the answer to do this. Academics should also go back to their libraries and read the likes of Hyman Minsky. He already warned during the 1990s that financial markets are by definition unstable.
Unfortunately also in the academic world there was herding behaviour. Those who dared to argue that for example Eugene Fama’s theory was build on lose sand got marginalised and treated as a paria. How long took it before the likes of Paul Krugman and Nouriel Roubini were taken seriously? Also among the brightest minds of the world Animal Spirits are king.
(1)Robert Shiller “The Subprime solution: How Today’s Global Financial Crisis Happened and What to Do about It” Princeton University Press, 2009
(2) See also Gary Stix “The Science of Bubbles & Busts”, Scientific American, 2009
Back in June we already wrote about the importance of psychology on issues such as inflation (The Unemployment – Inflation Theme). When inflation is discussed it is only a small step towards asset inflation and asset bubbles more specifically. One of the fuel components of the Great Credit Crisis was obviously the housing bubble. Before that people had only just shrugged off another crisis, that is the dotcom bubble.
Unfortunately in this debate on too many occasions one forgets to mention the responsibility of central banks and certainly that of former US Federal Reserve Chairman, Alan Greenspan who fuelled both bubbles with aggressive monetary policy like the way he handled the LTCM Crisis, Y2K and 9/11 events.
According to the Chairman it was not up to central banks to detect the build up of asset bubbles. The only thing a central bank should do in case of an asset bubble burst was to provide enough liquidity to the banking system in order that it would not collapse. Later on this was named the Greenspan doctrine and is closely related to issues such as lender-of-last-resort and moral hazard.
It is not our intention in this newsletter to overload Mr. Greenspan with all the sins of Israel, but do think that central banks should spend more time in studying asset price developments and should search for bubbles which could potentially wreck a (global) economy.
By trying to fix this problem we will have to look at how central banks and (investment) banks have been operating over the last 3-4 decades. Certainly since the Greenspan era there was this blind believe in the “Invisible Hand” and the Efficient Market Theory. There was this dogmatic conviction that the market was always right and would solve any problem. Putting this into doubt brings us on a collision course with one of the greatest economic thinkers of the 20th century Milton Friedman and his Chicago School.
We do not want to throw the free market principle over board. We are still strongly convinced that this has been the best socio-economic model in creating wealth. We all know by now what the credentials were of a state planned economy. So we will not touch this part of the discussion.
More importantly is to go to the core of the assumptions which are being made by the Efficient Market Theory and monetarists such as Milton Friedman. All of these theories start from the hypothesis that all market participants act rationally. Even Mr. Friedman knew that everybody has its individual preferences, but the concept of Homo Economicus, was so tempting as abstraction and strategic simplification, is the only way we can impose some intellectual order on the complexity of economic life.
This reasoning was the corner stone to theories such as the idea Mr. Friedman always taught us that employees and employers remain rational when negotiating on wages or deciding on investments and taking inflation into account this in an undiluted way.
But if this is true, bubbles could not exist. The Efficient Market Theory is also claiming that all information is priced into the market at any time and today’s price is the best indicator for the price of tomorrow. Furthermore the market always finds a balance between buyers and sellers at the right price. This equilibrium can only be disturbed due to a shock in the supply and demand chain, like for example the oil shock we have known in the 1970s. The thought of a previous price increase would lead to another is simply impossible to these classical economists.
However, how can one explain that from one day to another prices collapse? We all have seen the charts of stocks or real estate that fell of a cliff. Conventional economists have no explanation to this either. Even one of its greatest supporters, Alan Greenspan himself, admitted in 2008 he was spooked by this thought.
Behavioral economists may have the answer to this. They have done extensive research around the concept of “the illusion of money”. During a bubble build up it became obvious that investors are selectively ignoring obvious data and their behavior distorts price developments which inflates the price of the underlying asset. Dr. Robert Shiller, one of the great researchers on behavioral finance, applied this to the housing market and described it as follows: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.” (1)
First of all this comes close to experiences that most of us must have had in the past when trading or investing, in for example stocks. We can call it the state of denial where an investment is going against you, and one refuses to cut your losses. The self fulfilling prophecy in believing that a position will come back to its initial level and hopefully goes back above it. Information is selectively read and analysed and other data pointing to a justification of the correction is ignored.
This to us is already a first sign of the presence of irrational participants in financial markets.
Another lesson that we should have learned already long before the outbreak of the Great Credit Crisis is that markets are more driven by mutual trust than pure rational decision taking. One can detect this easily in the functioning of emerging markets where spreads are much wider compared to developed markets. The spread is the reflexion of available liquidity which can simply be brought back to trust as well. It is because not a lot of people are confident putting their savings at work in let’s say a country like Kazakhstan (just to name one) that it is difficult to find an equilibrium between a buyer and a seller.
This is only an emotional perception, which can easily trigger anxiety and can quickly turn into outright panic. This is what ultimately causes a collapse of prices, what we have seen on many occasions in the past. How many of us didn’t own stocks during the dotcom bubble which decimated overnight? All of us are driven by this illusion of money. It is the failure of this money illusion to account for inflation that will lead to emotion driven investment decisions with painful outcomes at the end of the process.
This is also what happened in the real estate market. Lenders had huge trust in economic data that over the past 70-80 years real estate prices never dropped on average on a national scale. They did not take into account that for example a rise in interest rates would have devastating effects on the repayment capacities of a large number of borrowers. This would lead to foreclosures and would negatively affect the value of houses. Unfortunately when the Federal Reserve started rising rates rapidly from 2003 onwards real estate prices did come under pressure.
Finally it does not take a neurologist or Sigmund Freud to know that there is a huge difference between starting from scratch and making EUR 2 million or having EUR 10 million and losing EUR 8 million but ending up with the same EUR 2 million. For our Homo Economicus, who behaves rationally, it would not make any difference. Unfortunately socio economic pressures around us indicate it makes a massive difference!
Neuroscientists have identified the source of this problem and it is located in the cortex of the brain. People who experienced a car accident with severe head injuries or even patients suffering from autism apparently do not have problems with a balancing exercise of gains versus losses. In both cases a malfunctioning of the ventromedial prefrontal cortex (VMPFC) is to blame. This does not mean that we should put the whole investment world on drugs which would switch out our VMPFC functioning in order to avoid bubbles in the future.
A more useful tool would be the model developed by a group of researchers at MIT which is known by the name “the Adaptive Market Hypothesis” (AMH). The framework they worked out is based upon the evolutionary theory and tries to predict increased volatility among investors. Basically it comes down to measuring the correlation between price changes that took place on a certain trading day and the influence of this on the price change the day after. (2)
This goes against the Efficient Market Theory that argues that price changes are randomly generated in time. However during the build up of a bubble they will identify high correlation, indicating that investors are showing herding behaviour and vice versa. The approach does not throw away the Efficient Market Theory as they recognize that markets can be in an efficient or rational mode but at times it can turn inefficient or irrational. After a bubble has burst the market can return into a more rational condition where investors’ view on the direction of the market is not influenced by each other. But during a bubble build up investors decisions will be highly correlated. We recognize this from street talk such as the TINA-hype (there-is-no-alternative) during the dotcom area and the subprime cycle.
If this AMH model proves to be reliable, it could be used as a tool by central banks to determine their monetary policy. This does not imply that a central bank should immediately start hiking rates when it detects a bubble but as a regulator it can start adjusting certain anomalies in the industry via legislation or rhetoric.
The AMH has also another advantage. It would help explaining why certain trading strategies are successful in certain specific markets. This would increase the performance of funds.
Now we are dealing with the aftermath of the Great Credit Crisis a debate should be started to revise the Efficient Market Theory and the unlimited trust in strength of “the invisible hand” of financial markets. Not only behavioural scientists have the answer to do this. Academics should also go back to their libraries and read the likes of Hyman Minsky. He already warned during the 1990s that financial markets are by definition unstable.
Unfortunately also in the academic world there was herding behaviour. Those who dared to argue that for example Eugene Fama’s theory was build on lose sand got marginalised and treated as a paria. How long took it before the likes of Paul Krugman and Nouriel Roubini were taken seriously? Also among the brightest minds of the world Animal Spirits are king.
(1)Robert Shiller “The Subprime solution: How Today’s Global Financial Crisis Happened and What to Do about It” Princeton University Press, 2009
(2) See also Gary Stix “The Science of Bubbles & Busts”, Scientific American, 2009
Tuesday 20 October 2009
And the Fed kept on printing...
Dear readers,
Recent USD weakness has brought more nervousness in the market. Apart from the EUR and AUD the currency is losing rapidly its value against gold. How is this compatible with our deflationary view? Last week we got further confirmation the deleveraging process is still far from over. US consumer credit contracted more than expected (- $12 billion), and it isn’t showing any sign what so ever of slowing down. Headlines like Barclays wanting to spin off a £ 4 billion structured credit portfolio should be considered as part of the deleveraging process the global economy is going through as well. This should keep consumer prices contained.
Then the Federal Reserve is doing its outmost best to inject some inflation into the system. This is certainly the case for some asset classes such as equities and commodities. Last weeks rhetoric from Fed members Tarullo and Fisher, who is famous for being a hawk, already indicated the Fed will stay on hold for “an extended period” of time. Also the Fed’s 5year-5year forward breakeven inflation rate has been dropping consistently since its spike back at the beginning of August. So no signs of inflation there either. But still gold is touching new historic highs against the USD.
The explanation behind all this might very well be a distrust from foreign investors in how the US Government will succeed in managing this Mount Everest of debt they are building up. There are reasons to believe central banks are already distancing themselves from the USD.
Recent US Treasury auctions showed however good appetite for USD debt paper. The bid-cover ratio has been well above 2%. And foreign central banks subscribed well above $ 250 bln. But the question is whether this is reflecting what is really going on behind the scenes. The Treasury International Capital Flows (TIC) data shows that foreign demand for USD paper is falling off a cliff.
Figure 1: Foreign Assets in the US: Net, Capital Inflow
Source: US Department of Commerce – Bureau of Economic Analysis
This has a direct impact on the value of the USD, as foreigners are net sellers of US assets. The US spending spree financed by foreigners during this decade is also very well illustrated in Figure 1. From 2001 onwards until the breakout of the Great Credit Crisis in 2007 foreigners bought massively US assets. It was part of the build up of a current account and trade balance deficit. The US was the consumer of last resort and the oil-exporting and Asian economies re-invested these revenues back into the US. This US asset buying stopped abruptly from the moment the US consumer couldn’t use his house as an ATM machine.
It does not take a rocket scientist to figure out what would happen to the USD if this structural foreign buying flow dries up. And it is certainly an issue for a country like the US which mounting debt depends on 50% of foreigners.
According to the TIC report, foreign central banks only bought roughly $ 75.7 bln (from Jan 09 till Aug 09). At first one can argue this is highly contradictive against data from the US Treasury auction, which is over $ 250 billion. Fortunately there is no paradox here.
First of all what you need to know is that the Federal Reserve acts as a custodian bank for foreign central banks that buy US Treasuries or Agency paper. In other words the Fed holds these bonds “in custody” for these foreign banks. The TIC data is only showing the amount of capital that is entering or leaving the US, but what happens on these custodian accounts at the Fed is not told.
A first look at these custodian accounts doesn’t raise any suspicion either. The amounts on these accounts have been growing over the years. But when we have a closer look one notices something odd. Central banks have not only been buying US Treasuries, but also US Agency bonds. This is paper issued by for example Freddie Mac and does not have the same guarantee like US Treasuries. Over the years foreign central banks were buyers of US Agencies. At the beginning of October 2008 a peak was reached at around $ 970.4 bio. Over the last 10-12 months this amount has dropped by $ 207.6 billion. US Treasuries on the other hand have risen by more than $ 600 billion.
Remember the TIC data, which is pointing at $ 75.7 of new money entering the US (from foreign central banks). So how does this explain the success of the US Treasury auctions?
Chris Martenson noticed the following phenomenon already back in June.
Foreign central banks are fully supporting the new issuances, but indirectly via their huge amounts of US Agency debt that they swap with the Federal Reserve. This avoids a situation where the Federal Reserve has to start buying its own paper. Imagine which kind of panic this would cause in the bond market.
So basically out of the sale of their US Agency paper, foreign central banks keep on supporting the Fed in buying new US Treasury bonds. But in some way or another, it is ultimately the Fed that is buying its own paper.
However, as we learn from the TIC data, compared to the total of USD 600 billion that has been issued, only USD 75.7 of new money is coming from foreign central banks. In the meantime $ 552.6 billion of private money has been repatriated back abroad. This shows that there is a negative flow leaving the US and explains why the USD is has come under so much pressure recently.
Recent USD weakness has brought more nervousness in the market. Apart from the EUR and AUD the currency is losing rapidly its value against gold. How is this compatible with our deflationary view? Last week we got further confirmation the deleveraging process is still far from over. US consumer credit contracted more than expected (- $12 billion), and it isn’t showing any sign what so ever of slowing down. Headlines like Barclays wanting to spin off a £ 4 billion structured credit portfolio should be considered as part of the deleveraging process the global economy is going through as well. This should keep consumer prices contained.
Then the Federal Reserve is doing its outmost best to inject some inflation into the system. This is certainly the case for some asset classes such as equities and commodities. Last weeks rhetoric from Fed members Tarullo and Fisher, who is famous for being a hawk, already indicated the Fed will stay on hold for “an extended period” of time. Also the Fed’s 5year-5year forward breakeven inflation rate has been dropping consistently since its spike back at the beginning of August. So no signs of inflation there either. But still gold is touching new historic highs against the USD.
The explanation behind all this might very well be a distrust from foreign investors in how the US Government will succeed in managing this Mount Everest of debt they are building up. There are reasons to believe central banks are already distancing themselves from the USD.
Recent US Treasury auctions showed however good appetite for USD debt paper. The bid-cover ratio has been well above 2%. And foreign central banks subscribed well above $ 250 bln. But the question is whether this is reflecting what is really going on behind the scenes. The Treasury International Capital Flows (TIC) data shows that foreign demand for USD paper is falling off a cliff.
Figure 1: Foreign Assets in the US: Net, Capital Inflow
Source: US Department of Commerce – Bureau of Economic Analysis
This has a direct impact on the value of the USD, as foreigners are net sellers of US assets. The US spending spree financed by foreigners during this decade is also very well illustrated in Figure 1. From 2001 onwards until the breakout of the Great Credit Crisis in 2007 foreigners bought massively US assets. It was part of the build up of a current account and trade balance deficit. The US was the consumer of last resort and the oil-exporting and Asian economies re-invested these revenues back into the US. This US asset buying stopped abruptly from the moment the US consumer couldn’t use his house as an ATM machine.
It does not take a rocket scientist to figure out what would happen to the USD if this structural foreign buying flow dries up. And it is certainly an issue for a country like the US which mounting debt depends on 50% of foreigners.
According to the TIC report, foreign central banks only bought roughly $ 75.7 bln (from Jan 09 till Aug 09). At first one can argue this is highly contradictive against data from the US Treasury auction, which is over $ 250 billion. Fortunately there is no paradox here.
First of all what you need to know is that the Federal Reserve acts as a custodian bank for foreign central banks that buy US Treasuries or Agency paper. In other words the Fed holds these bonds “in custody” for these foreign banks. The TIC data is only showing the amount of capital that is entering or leaving the US, but what happens on these custodian accounts at the Fed is not told.
A first look at these custodian accounts doesn’t raise any suspicion either. The amounts on these accounts have been growing over the years. But when we have a closer look one notices something odd. Central banks have not only been buying US Treasuries, but also US Agency bonds. This is paper issued by for example Freddie Mac and does not have the same guarantee like US Treasuries. Over the years foreign central banks were buyers of US Agencies. At the beginning of October 2008 a peak was reached at around $ 970.4 bio. Over the last 10-12 months this amount has dropped by $ 207.6 billion. US Treasuries on the other hand have risen by more than $ 600 billion.
Remember the TIC data, which is pointing at $ 75.7 of new money entering the US (from foreign central banks). So how does this explain the success of the US Treasury auctions?
Chris Martenson noticed the following phenomenon already back in June.
Foreign central banks are fully supporting the new issuances, but indirectly via their huge amounts of US Agency debt that they swap with the Federal Reserve. This avoids a situation where the Federal Reserve has to start buying its own paper. Imagine which kind of panic this would cause in the bond market.
So basically out of the sale of their US Agency paper, foreign central banks keep on supporting the Fed in buying new US Treasury bonds. But in some way or another, it is ultimately the Fed that is buying its own paper.
However, as we learn from the TIC data, compared to the total of USD 600 billion that has been issued, only USD 75.7 of new money is coming from foreign central banks. In the meantime $ 552.6 billion of private money has been repatriated back abroad. This shows that there is a negative flow leaving the US and explains why the USD is has come under so much pressure recently.
Thursday 1 October 2009
US (Un)-Employment
Dear readers,
In last weeks’ Givanomics we explained the New Normal. In summary the New Normal stands for much lower economic growth, higher public debts and unemployment rates compared to the levels we were used to before the Great Credit Crisis 2007-2009.
This week we will have a closer look at some data of the US labour market in specific. The data we use is obtained by the Bureau of Labour Statistics, the Federal Reserve and research company Millennium Wave Investments run by John Mauldin.
Last month US unemployment hit 9.7%, getting close at the levels of the 1980-1983 economic recession. In real numbers, based upon a total labour force of 154,577,000 people available for the labour market, almost 15 million are out of a job right now. Over the last two years the US economy lost around 8 million of jobs.
This number is actually even worse if one takes into account the number of people who lost their full time job and have to accept a lower level part-time job. When this group is taken into account the unemployment number would be around 16.8% (this is also known as U-6 unemployment). Then we are not taking into account those who still would like to work but are not available anymore to the job market. Bear in mind in order to be part of the US labour market one needs to be registered. Those who lost all hope because of disappointment fall out of this database. Despite the fact that this is percentagewise a very small group, it would bring the unemployment number closer to 20%.
Reverting to the old normal would mean that 8 million people would need to be put back at work. On top of that one needs to take into account that the US labour market needs on average between 125,000 and 150,000 new jobs every month to accomodate newcomers to the job market. This comes from migration, people who graduate and/or women who are still entering the labour force.
Like there is subordination in a debt structure there will be a hierarchy in the job market to put all these people back to work. This will work out as follows:
The first signs of recovery in the labour market will be seen in the numbers of hours worked on a weekly basis. The first thing an employer usually does when demand is dropping, is to slow down the production process. Job lay offs are the last drastic measure to rationalise the business. From the moment that economic activity is picking up again the average hours worked in a week will start rising again. This fell from 34 hours a week to a record low of 33 hours last June.
Before there will be a substantial recruitment wave in the unemployed labour force, employers will ask part-time workers to work a bit longer, driving up the weekly hours worked. So these will be the first who will turn back to full employment. Then, if we get back to pre-recession levels of 33.8 – 34 hours worked a week, companies will hire back out of the available labour pool of fully unemployed people. The newcomers on the job market however will be the group who will find it most difficult to find a decent job.
When we extrapolate this group for the next 5 years this means that the US job market will need to add 150,000 or 125,000 * 12 * 5 or 7.5 and 9 million jobs. This comes on top of the 8 million people that lost their jobs during the current crisis.
This is the challenge the US economy will face: creating between 15.5 and 17 million jobs over the next 5 years. If we use the lowest number this still would mean that the US job market should grow on a monthly basis by 258,000, and this every month for the next 5 years.
This is a performance that the US economy not even matched during the “Old Normal”. During the booming years this average was around 230,000. If this is averaged out over the last 10 years the average was only 50,000. This was of course with a recession incorporated, but during the prosperous times of the Clinton years the US economy created only 150,000 on average every month.
We can almost guarantee you this will not happen in the absence of a Shadow Banking system that was the driving engine of cheap credit and overconsumption. As far as unemployment is concerned this is the New Normal. The US economy will have to adjust to a new environment of much higher unemployment rates which will have, in turn, a severe impact on spending.
In last weeks’ Givanomics we explained the New Normal. In summary the New Normal stands for much lower economic growth, higher public debts and unemployment rates compared to the levels we were used to before the Great Credit Crisis 2007-2009.
This week we will have a closer look at some data of the US labour market in specific. The data we use is obtained by the Bureau of Labour Statistics, the Federal Reserve and research company Millennium Wave Investments run by John Mauldin.
Last month US unemployment hit 9.7%, getting close at the levels of the 1980-1983 economic recession. In real numbers, based upon a total labour force of 154,577,000 people available for the labour market, almost 15 million are out of a job right now. Over the last two years the US economy lost around 8 million of jobs.
This number is actually even worse if one takes into account the number of people who lost their full time job and have to accept a lower level part-time job. When this group is taken into account the unemployment number would be around 16.8% (this is also known as U-6 unemployment). Then we are not taking into account those who still would like to work but are not available anymore to the job market. Bear in mind in order to be part of the US labour market one needs to be registered. Those who lost all hope because of disappointment fall out of this database. Despite the fact that this is percentagewise a very small group, it would bring the unemployment number closer to 20%.
Reverting to the old normal would mean that 8 million people would need to be put back at work. On top of that one needs to take into account that the US labour market needs on average between 125,000 and 150,000 new jobs every month to accomodate newcomers to the job market. This comes from migration, people who graduate and/or women who are still entering the labour force.
Like there is subordination in a debt structure there will be a hierarchy in the job market to put all these people back to work. This will work out as follows:
The first signs of recovery in the labour market will be seen in the numbers of hours worked on a weekly basis. The first thing an employer usually does when demand is dropping, is to slow down the production process. Job lay offs are the last drastic measure to rationalise the business. From the moment that economic activity is picking up again the average hours worked in a week will start rising again. This fell from 34 hours a week to a record low of 33 hours last June.
Before there will be a substantial recruitment wave in the unemployed labour force, employers will ask part-time workers to work a bit longer, driving up the weekly hours worked. So these will be the first who will turn back to full employment. Then, if we get back to pre-recession levels of 33.8 – 34 hours worked a week, companies will hire back out of the available labour pool of fully unemployed people. The newcomers on the job market however will be the group who will find it most difficult to find a decent job.
When we extrapolate this group for the next 5 years this means that the US job market will need to add 150,000 or 125,000 * 12 * 5 or 7.5 and 9 million jobs. This comes on top of the 8 million people that lost their jobs during the current crisis.
This is the challenge the US economy will face: creating between 15.5 and 17 million jobs over the next 5 years. If we use the lowest number this still would mean that the US job market should grow on a monthly basis by 258,000, and this every month for the next 5 years.
This is a performance that the US economy not even matched during the “Old Normal”. During the booming years this average was around 230,000. If this is averaged out over the last 10 years the average was only 50,000. This was of course with a recession incorporated, but during the prosperous times of the Clinton years the US economy created only 150,000 on average every month.
We can almost guarantee you this will not happen in the absence of a Shadow Banking system that was the driving engine of cheap credit and overconsumption. As far as unemployment is concerned this is the New Normal. The US economy will have to adjust to a new environment of much higher unemployment rates which will have, in turn, a severe impact on spending.
Friday 25 September 2009
The New Normal
We may have mentioned the New Normal already a couple of times in our previous newsletters. The term was first introduced by Mohammed El-Erian, co-CIO of Pimco, in May and has triggered a debate among economists on what this means for the long future.
Let us first explain what is meant with this New Normal. Before the Great Credit Crisis broke out in 2007 we were used to robust economic growth numbers north of 3% year on year and a labour market which was close to full employment. The private sector was flourishing and benefitted from a world that got more interconnected.
Since the Great Credit Crisis 2007-2009 all this has come to an end and we will have to adjust ourselves to a new equilibrium which is created by more regulation, higher taxes, less leverage, lower growth and higher unemployment.
There are a number of valid reasons why it will be hard to return to the Old Normal for the next 10 or even 20 years.
The cycle of cheap credit, which was the fuel of the economic growth engine, is definitely behind us. The Shadow banking system collapsed and quite rightly regulators are looking at ways to shut that door for good. Of course markets move in cycles, and there will be again a period in the future where banks will be able to loosen their credit standards. But this will take time. The first phase of deleveraging of the banking sector is behind us. This was an abrupt and disruptive one. Now the second phase has started and should be more orderly. Nevertheless after the residential property market, commercial real estate and credit card write downs will force banks to deleverage their balance sheets further. This means that in the years ahead the supply of credit will be limited and this will be reflected in economic growth numbers.
Then there was the global imbalance of Asian and oil exporting countries that were funding the American spending spree. Although nothing fundamentally has been done yet about this problem, recent rhetoric from the BRIC countries (Brazil-Russia-India-China) shows there is growing caution to invest in US paper which is printed to finance the public household deficits. The Old Normal was based upon a model where the rest of the world was producing cheap products to satisfy American Consumerism and in return received US fixed income paper for it. THE solution to this problem would be that emerging market economies start buying the products that they produce themselves but this is not going to happen immediately and therefore growth will be at a much lower pace.
After the Lehman collapse the private economy imploded and governments all over the world had to issue rescue packages to avoid the global economy coming to a complete stand still. Apart from the banking sector which needed to be rescued anyway for the sake of the deposits of the public, the manufacturing industry needed a helping hand too. The US car industry for example was almost nationalised. Other industries got all kind of life lines and stimulus packages as well and most of them are still in place. Withdrawing these incentives would trigger a new turmoil. As Bill Gross, CEO of Pimco would say, the invisible hand of Adam Smith has been replaced by the visible hand of the public sector.
The US housing market could be considered as the crucial cylinder of the economic growth engine. After the collapse of the dotcom bubble the American consumer used his house in stead of the stock market to keep on spending via several creative refinancing techniques. As a consequence homeownership rose to approximately 70% in the US, but we now know that a lot of people should never have qualified for a home in the first place. At least not if prudent lending practices would have been applied by banks. Under the New Normal homeownership will drop again to pre-housing bubble levels of around 65%. As a consequence, this will not be a driving force for economic growth and the economy will grow at a lower pace as mentioned previously.
The gigantic stimulus and rescue packages issued by governments across the world have derailed the public finances and the taxpayer will eventually pick up the tab. In Europe everybody remembers a similar episode during the early eighties where tried to deal with the aftershocks of the Oil Crises. Fortunately they had the Maastricht Stability Pact to bring their finances back under control. However the problem now is the threat of the aging population in the Western World which is further going to jeopardise the public household deficits of European, American and Japanese governments. This environment will also contribute to lower economic growth.
We concur therefore with Bill Gross’s conclusions that the outcome of this New Normal will be an environment where rates will remain low for a considerable period of time, the USD will face serious difficulties, above average growth will come from new economies in Asia. He even adds two more valid points to this New Normal to be taken into account:
“The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.” (1)
(1)Bill Gross “On the course to a New Normal” Investment Outlook, Pimco, Sep 2009
Let us first explain what is meant with this New Normal. Before the Great Credit Crisis broke out in 2007 we were used to robust economic growth numbers north of 3% year on year and a labour market which was close to full employment. The private sector was flourishing and benefitted from a world that got more interconnected.
Since the Great Credit Crisis 2007-2009 all this has come to an end and we will have to adjust ourselves to a new equilibrium which is created by more regulation, higher taxes, less leverage, lower growth and higher unemployment.
There are a number of valid reasons why it will be hard to return to the Old Normal for the next 10 or even 20 years.
The cycle of cheap credit, which was the fuel of the economic growth engine, is definitely behind us. The Shadow banking system collapsed and quite rightly regulators are looking at ways to shut that door for good. Of course markets move in cycles, and there will be again a period in the future where banks will be able to loosen their credit standards. But this will take time. The first phase of deleveraging of the banking sector is behind us. This was an abrupt and disruptive one. Now the second phase has started and should be more orderly. Nevertheless after the residential property market, commercial real estate and credit card write downs will force banks to deleverage their balance sheets further. This means that in the years ahead the supply of credit will be limited and this will be reflected in economic growth numbers.
Then there was the global imbalance of Asian and oil exporting countries that were funding the American spending spree. Although nothing fundamentally has been done yet about this problem, recent rhetoric from the BRIC countries (Brazil-Russia-India-China) shows there is growing caution to invest in US paper which is printed to finance the public household deficits. The Old Normal was based upon a model where the rest of the world was producing cheap products to satisfy American Consumerism and in return received US fixed income paper for it. THE solution to this problem would be that emerging market economies start buying the products that they produce themselves but this is not going to happen immediately and therefore growth will be at a much lower pace.
After the Lehman collapse the private economy imploded and governments all over the world had to issue rescue packages to avoid the global economy coming to a complete stand still. Apart from the banking sector which needed to be rescued anyway for the sake of the deposits of the public, the manufacturing industry needed a helping hand too. The US car industry for example was almost nationalised. Other industries got all kind of life lines and stimulus packages as well and most of them are still in place. Withdrawing these incentives would trigger a new turmoil. As Bill Gross, CEO of Pimco would say, the invisible hand of Adam Smith has been replaced by the visible hand of the public sector.
The US housing market could be considered as the crucial cylinder of the economic growth engine. After the collapse of the dotcom bubble the American consumer used his house in stead of the stock market to keep on spending via several creative refinancing techniques. As a consequence homeownership rose to approximately 70% in the US, but we now know that a lot of people should never have qualified for a home in the first place. At least not if prudent lending practices would have been applied by banks. Under the New Normal homeownership will drop again to pre-housing bubble levels of around 65%. As a consequence, this will not be a driving force for economic growth and the economy will grow at a lower pace as mentioned previously.
The gigantic stimulus and rescue packages issued by governments across the world have derailed the public finances and the taxpayer will eventually pick up the tab. In Europe everybody remembers a similar episode during the early eighties where tried to deal with the aftershocks of the Oil Crises. Fortunately they had the Maastricht Stability Pact to bring their finances back under control. However the problem now is the threat of the aging population in the Western World which is further going to jeopardise the public household deficits of European, American and Japanese governments. This environment will also contribute to lower economic growth.
We concur therefore with Bill Gross’s conclusions that the outcome of this New Normal will be an environment where rates will remain low for a considerable period of time, the USD will face serious difficulties, above average growth will come from new economies in Asia. He even adds two more valid points to this New Normal to be taken into account:
“The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.” (1)
(1)Bill Gross “On the course to a New Normal” Investment Outlook, Pimco, Sep 2009
Thursday 17 September 2009
True reasons of USD weakness and other misconceptions...
Dear readers,
Major theme of this week is the USD under continued pressure driven by two factors : further hopes on recovery, and inflation expectations. In our opinion both are overestimated. The question is however whether these are the true reasons behind this current move?
As far as the recovery theme concerns investors are only listening to what they want to hear. Markets rallied since the beginning of the week on further so called upbeat comments from government officials, central bankers and crucial market players.
Treasury Secretary Timothy Geithner was the first one to come out with comments over the weekend regarding plans to wind down the stimulus packages for banks. This contributed to another boost for bank stocks.
Then central banks officials such as Chairman Ben Bernanke or former Chairman Paul Volcker with comments on the end of the recession. Both though added to this the prospect of low sluggish growth with a severe risk of a double dip. That part however was ignored by the market.
Last but not least Warren Buffet who fuelled the debate by saying some stocks are cheap. First of all he did not mention which stocks were a bargain, but the market generalised his comment and buys whatever is available. Furthermore Mr. Buffet’s comments on the state of the economy were not that upbeat. He literally said “the economy has hit a plateau at bottom”. This to us can be placed under similar comments like Mohammed El-Erian from PIMCO who previously mentioned the global economy will look for a New Normal which will be lower economic growth compared to pre Credit Crunch GDP numbers. An economy at plateau bottom is flat and does not give any signs of upward potential. It is like a plateau in the Alps. It is a temporary relief, but around the corner there are two choices. Either a steep uphill climb resumes or a steep descend is waiting. Nevertheless the market is in a buying mood and ignores for the time being the real warning signs.
We receive further equity flow indications that this rally since August is mainly driven by retail money and logarithmic trading platforms. Major institutional investors keep on being sidelined. We plan to dedicate a separate piece on equity flows caused by algorithmic trading platforms in the week ahead, which will give an interesting inside in what is driving these stock markets recently.
Re. inflation expectations, it’s not clear-cut either. The hype around gold going through $ 1,000 an ounce to us is not a signal of increased inflation risks. We backtested the correlation between gold and inflation over time and there is no clear correlation between them. We compared the price action of the spot price of Gold (in USD terms) versus US CPI over a period of 40 years on an annual basis and also over a period of 30 years on a quarterly basis. The first one gave a negative correlation of 0.1606, the second only +0.1252. This will make you think twice before buying a Gold ETF from a pushy broker that wants to sell this as a protection against inflation risks.
To us the only indicator which would signal a return of inflation will be a rise in the velocity of money V, a topic that we broadly discussed on several occasions in our previous newsletters (remember GDP = M*V). This is still dropping however and indicates that central banks will not take liquidity back in the short term. V rises in an environment where financial innovation flourishes. Securitization was the fuel that drove the M2 & M3 engine. But at this moment we are still in the middle of a deleveraging process and the securitization market is frozen.
M2 is topping off as well after a massive liquidity injection of the Federal Reserve at the end of 2008 (Figure 1). Luckily they did this as, given our equation, the economy would be in an even deeper recession right now. This also means that at this moment the Fed will have no other choice than keep on printing money. How much? To be honest they do not know either and if they would know they will certainly not communicate it to the market as the bond market would start throwing up spontaneously. (1)
Figure 1 M2
Source: Board of Governors of Federal Reserve
The question whether this potential further rise in M2 is going to threaten the USD is hard to answer. To cause a drop in the USD, credit growth by banks needs to rise. This is not the case right now as financial innovation is put on hold and a lot of this money is still sidelined on balance sheets and does not boost economic activity. In this case it can not create selling pressure in the foreign exchange market.
Also, rising inflation expectations from the massive debt build up from various US stimulus packages is another explanation for the current USD weakness. We have always warned that this debt build up would end up in tears sooner rather than later, and quite correctly this will have an impact on the value of the USD. However if we look at the 5 year forward USD inflation curve tracked by the Fed, there are no signs whatsoever either about growing concern on this part. As a matter of fact forward inflation expectations have been falling since the end of July. This is in line with the Federal Reserve’s concern on deflation at the moment. (Figure 2)
Figure 2 Fed’s 5y-5y forward break-even inflation rate
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
A more valid point for USD weakness would be an increase in risk appetite. Rising stock markets have been a sign of falling risk aversion for several months now. The Volatility Index on the Chicago Board Option Exchange (VIX) fell from above 50 during the turmoil of financial markets at the beginning of the year to 23.44 today. Together with this renewed risk appetite we see the carry trade returning again. However, in the past, this trade was usually set up via low yielding currencies such as the JPY and or CHF ; at this moment the USD is used as funding currency to invest in other high yielding places such as AUD or NZD.
This is only possible when the market does not expect any rate hikes soon from the Federal Reserve as this would damage their funding play. This is not the case with a Fed still concerned about deflation as mentioned above. As long as this is the case this creates automatically additional selling pressure in the FX market as USD loans are sold and swapped for other high yielding currencies.
Then again, current USD weakness could also partially be explained by a trade balance and current account deficit that is showing signs to start widening again. Although the shrinking of both deficits were a positive development in working away one of the major global imbalances, this will only be a temporarily development. The reduction of these deficits was more due to the fall in import prices because global trade came to a standstill after the Lehmann collapse.
The chances that this may have come to an end are rather high and creates more USD pressure.
(1) For more in depth macro analysis we refer to John Mauldin, “Elements of Deflation, Part 2” Sep 11 2009, Thoughts from the Frontline
Major theme of this week is the USD under continued pressure driven by two factors : further hopes on recovery, and inflation expectations. In our opinion both are overestimated. The question is however whether these are the true reasons behind this current move?
As far as the recovery theme concerns investors are only listening to what they want to hear. Markets rallied since the beginning of the week on further so called upbeat comments from government officials, central bankers and crucial market players.
Treasury Secretary Timothy Geithner was the first one to come out with comments over the weekend regarding plans to wind down the stimulus packages for banks. This contributed to another boost for bank stocks.
Then central banks officials such as Chairman Ben Bernanke or former Chairman Paul Volcker with comments on the end of the recession. Both though added to this the prospect of low sluggish growth with a severe risk of a double dip. That part however was ignored by the market.
Last but not least Warren Buffet who fuelled the debate by saying some stocks are cheap. First of all he did not mention which stocks were a bargain, but the market generalised his comment and buys whatever is available. Furthermore Mr. Buffet’s comments on the state of the economy were not that upbeat. He literally said “the economy has hit a plateau at bottom”. This to us can be placed under similar comments like Mohammed El-Erian from PIMCO who previously mentioned the global economy will look for a New Normal which will be lower economic growth compared to pre Credit Crunch GDP numbers. An economy at plateau bottom is flat and does not give any signs of upward potential. It is like a plateau in the Alps. It is a temporary relief, but around the corner there are two choices. Either a steep uphill climb resumes or a steep descend is waiting. Nevertheless the market is in a buying mood and ignores for the time being the real warning signs.
We receive further equity flow indications that this rally since August is mainly driven by retail money and logarithmic trading platforms. Major institutional investors keep on being sidelined. We plan to dedicate a separate piece on equity flows caused by algorithmic trading platforms in the week ahead, which will give an interesting inside in what is driving these stock markets recently.
Re. inflation expectations, it’s not clear-cut either. The hype around gold going through $ 1,000 an ounce to us is not a signal of increased inflation risks. We backtested the correlation between gold and inflation over time and there is no clear correlation between them. We compared the price action of the spot price of Gold (in USD terms) versus US CPI over a period of 40 years on an annual basis and also over a period of 30 years on a quarterly basis. The first one gave a negative correlation of 0.1606, the second only +0.1252. This will make you think twice before buying a Gold ETF from a pushy broker that wants to sell this as a protection against inflation risks.
To us the only indicator which would signal a return of inflation will be a rise in the velocity of money V, a topic that we broadly discussed on several occasions in our previous newsletters (remember GDP = M*V). This is still dropping however and indicates that central banks will not take liquidity back in the short term. V rises in an environment where financial innovation flourishes. Securitization was the fuel that drove the M2 & M3 engine. But at this moment we are still in the middle of a deleveraging process and the securitization market is frozen.
M2 is topping off as well after a massive liquidity injection of the Federal Reserve at the end of 2008 (Figure 1). Luckily they did this as, given our equation, the economy would be in an even deeper recession right now. This also means that at this moment the Fed will have no other choice than keep on printing money. How much? To be honest they do not know either and if they would know they will certainly not communicate it to the market as the bond market would start throwing up spontaneously. (1)
Figure 1 M2
Source: Board of Governors of Federal Reserve
The question whether this potential further rise in M2 is going to threaten the USD is hard to answer. To cause a drop in the USD, credit growth by banks needs to rise. This is not the case right now as financial innovation is put on hold and a lot of this money is still sidelined on balance sheets and does not boost economic activity. In this case it can not create selling pressure in the foreign exchange market.
Also, rising inflation expectations from the massive debt build up from various US stimulus packages is another explanation for the current USD weakness. We have always warned that this debt build up would end up in tears sooner rather than later, and quite correctly this will have an impact on the value of the USD. However if we look at the 5 year forward USD inflation curve tracked by the Fed, there are no signs whatsoever either about growing concern on this part. As a matter of fact forward inflation expectations have been falling since the end of July. This is in line with the Federal Reserve’s concern on deflation at the moment. (Figure 2)
Figure 2 Fed’s 5y-5y forward break-even inflation rate
© Bloomberg L.P. Used with permission. Visit www.bloomberg.com
A more valid point for USD weakness would be an increase in risk appetite. Rising stock markets have been a sign of falling risk aversion for several months now. The Volatility Index on the Chicago Board Option Exchange (VIX) fell from above 50 during the turmoil of financial markets at the beginning of the year to 23.44 today. Together with this renewed risk appetite we see the carry trade returning again. However, in the past, this trade was usually set up via low yielding currencies such as the JPY and or CHF ; at this moment the USD is used as funding currency to invest in other high yielding places such as AUD or NZD.
This is only possible when the market does not expect any rate hikes soon from the Federal Reserve as this would damage their funding play. This is not the case with a Fed still concerned about deflation as mentioned above. As long as this is the case this creates automatically additional selling pressure in the FX market as USD loans are sold and swapped for other high yielding currencies.
Then again, current USD weakness could also partially be explained by a trade balance and current account deficit that is showing signs to start widening again. Although the shrinking of both deficits were a positive development in working away one of the major global imbalances, this will only be a temporarily development. The reduction of these deficits was more due to the fall in import prices because global trade came to a standstill after the Lehmann collapse.
The chances that this may have come to an end are rather high and creates more USD pressure.
(1) For more in depth macro analysis we refer to John Mauldin, “Elements of Deflation, Part 2” Sep 11 2009, Thoughts from the Frontline
Friday 28 August 2009
Dancing on the Ceiling
Dear readers,
This week we move away from our macro-economic analysis and focus on a worrisome development in the banking sector that was brought to our attention via a Bloomberg story posted this Friday.
Despite the enormous fiscal cost to the tax payer around the world, the past twelve months have been a treasure for global macro players like us who try to detect imbalances and exploit these opportunities or at least protect our investments against these excesses. We were privileged to sit on the first row to see the Great Credit Crisis unfold and it gave us a massive amount of inspiration to write about it. This even ended up in an invitation from Moorad Choudhry to contribute a chapter on the Origin of a Crisis for the 3rd edition of one of his many books he has published so far. More info on this you will find on http://www.palgrave.com/Products/title.aspx?PID=335493
This throws us immediately into our subject of this week. One can easily sum up more than 10 reasons that can be held responsible for causing this crisis. Each of them has a different weighting. For example despite what populists may argue the bonus culture is not top on the list but is rather a Tier 3 or 4 factor in all this. The combination of leverage and the fact that financial firms chose not to transfer credit risk could be appointed as one of the root causes of the financial crisis.
We are now in the midst of a process that governments and regulators are trying to fix the system and make the rules more robust to prevent this from happening again. Certainly one should hope that we would not return to the old sins that brought us into trouble in the first place. Unfortunately when we read the Bloomberg headline we were shocked that some market players return to their old bad habits. It is as if the party has just started again and everybody is singing Lionel Richie's song " We are dancing on the ceiling."
At this moment banks are gearing up their lending to buyers of high-yield corporate loans and mortgages and this at a pace which is even faster then before the outbreak of the Great Credit Crisis in July 2007. To quote Bob Franz, co-head of syndicated loans at CSFB “I am surprised by how quickly the market has become receptive to leverage again.”
According to data from the Fed one can see that among the 18 prime dealers who bid for US Treasuries there is a total of $ 27.6 billion of securities held as collateral for financings lasting more than one day as of August 12. This is up 75% since the beginning of May!!!
The increase proves money is being used for riskier home loans, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by
Fannie Mae, Freddie Mac and/ or Ginnie Mae.
Furthermore the increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments. Fortunately lenders are asking more collateral for the loans.
We have no issues with the technique of using a bit of leverage especially when a fair amount of collateral is behind it. Risk needs to be taken. This is crucial to our financial capitalistic system. It may sound harsh but a market economy needs to some degree bankruptcies as it is a healthy sign of risk taking. A financial system so stable that no bankruptcy would take place would be an indication that risk taking is (too) low and this will negatively affect entrepreneurship.
The only issue we have is that there is a justified political pressure on banks to start lending again, but this would be the last form one would expect to return. To the degree leverage coming back represents a normalization of the markets but the idea it should be part of any permanent residential or commercial mortgage securities portfolio strategy is not clever. It is like a heart patient who just recovered from a heart transplant and is immediately trying to run a marathon again.
The risk now is that this new credit leads to more losses at a time when consumer and corporate default rates are rising. Company defaults may increase to 12.2 percent worldwide in the fourth quarter, from 10.7 percent in July, according to rating agency Moody’s. Then there still is the ticking time bomb of commercial real estate.
The end game of this is very colourful described by Julian Mann, a $ 5 billion fund manager in California, “If you leverage up an asset at these already elevated prices, and the underlying fundamentals, like termites, start to chew through the performance of the security, at some point it becomes unsustainable.” We don’t have to remind you what happened from July 2007 onwards…
Stepping back from the experience of the current crisis, and looking forward, it is clear that the issue of financial stability should remain a central focus. The experience of the past few decades in both emerging markets and advanced economies shows the pervasiveness of financial crises. These crises, signals of financial instability and the failure of the proper working of the financial system, have important economic and financial consequences, and usually lead to severe economic contractions that may either be short-lived or persist over time. If the real effects persist, the long-run potential and actual growth rate of an economy may be significantly lowered, negatively affecting long term welfare. (1)
(1) Viral Acharya and Matthew Richardson “Restoring Financial Stability. How to Repair a Failed System.” NYU Stern, 2009
This week we move away from our macro-economic analysis and focus on a worrisome development in the banking sector that was brought to our attention via a Bloomberg story posted this Friday.
Despite the enormous fiscal cost to the tax payer around the world, the past twelve months have been a treasure for global macro players like us who try to detect imbalances and exploit these opportunities or at least protect our investments against these excesses. We were privileged to sit on the first row to see the Great Credit Crisis unfold and it gave us a massive amount of inspiration to write about it. This even ended up in an invitation from Moorad Choudhry to contribute a chapter on the Origin of a Crisis for the 3rd edition of one of his many books he has published so far. More info on this you will find on http://www.palgrave.com/Products/title.aspx?PID=335493
This throws us immediately into our subject of this week. One can easily sum up more than 10 reasons that can be held responsible for causing this crisis. Each of them has a different weighting. For example despite what populists may argue the bonus culture is not top on the list but is rather a Tier 3 or 4 factor in all this. The combination of leverage and the fact that financial firms chose not to transfer credit risk could be appointed as one of the root causes of the financial crisis.
We are now in the midst of a process that governments and regulators are trying to fix the system and make the rules more robust to prevent this from happening again. Certainly one should hope that we would not return to the old sins that brought us into trouble in the first place. Unfortunately when we read the Bloomberg headline we were shocked that some market players return to their old bad habits. It is as if the party has just started again and everybody is singing Lionel Richie's song " We are dancing on the ceiling."
At this moment banks are gearing up their lending to buyers of high-yield corporate loans and mortgages and this at a pace which is even faster then before the outbreak of the Great Credit Crisis in July 2007. To quote Bob Franz, co-head of syndicated loans at CSFB “I am surprised by how quickly the market has become receptive to leverage again.”
According to data from the Fed one can see that among the 18 prime dealers who bid for US Treasuries there is a total of $ 27.6 billion of securities held as collateral for financings lasting more than one day as of August 12. This is up 75% since the beginning of May!!!
The increase proves money is being used for riskier home loans, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by
Fannie Mae, Freddie Mac and/ or Ginnie Mae.
Furthermore the increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments. Fortunately lenders are asking more collateral for the loans.
We have no issues with the technique of using a bit of leverage especially when a fair amount of collateral is behind it. Risk needs to be taken. This is crucial to our financial capitalistic system. It may sound harsh but a market economy needs to some degree bankruptcies as it is a healthy sign of risk taking. A financial system so stable that no bankruptcy would take place would be an indication that risk taking is (too) low and this will negatively affect entrepreneurship.
The only issue we have is that there is a justified political pressure on banks to start lending again, but this would be the last form one would expect to return. To the degree leverage coming back represents a normalization of the markets but the idea it should be part of any permanent residential or commercial mortgage securities portfolio strategy is not clever. It is like a heart patient who just recovered from a heart transplant and is immediately trying to run a marathon again.
The risk now is that this new credit leads to more losses at a time when consumer and corporate default rates are rising. Company defaults may increase to 12.2 percent worldwide in the fourth quarter, from 10.7 percent in July, according to rating agency Moody’s. Then there still is the ticking time bomb of commercial real estate.
The end game of this is very colourful described by Julian Mann, a $ 5 billion fund manager in California, “If you leverage up an asset at these already elevated prices, and the underlying fundamentals, like termites, start to chew through the performance of the security, at some point it becomes unsustainable.” We don’t have to remind you what happened from July 2007 onwards…
Stepping back from the experience of the current crisis, and looking forward, it is clear that the issue of financial stability should remain a central focus. The experience of the past few decades in both emerging markets and advanced economies shows the pervasiveness of financial crises. These crises, signals of financial instability and the failure of the proper working of the financial system, have important economic and financial consequences, and usually lead to severe economic contractions that may either be short-lived or persist over time. If the real effects persist, the long-run potential and actual growth rate of an economy may be significantly lowered, negatively affecting long term welfare. (1)
(1) Viral Acharya and Matthew Richardson “Restoring Financial Stability. How to Repair a Failed System.” NYU Stern, 2009
Wednesday 12 August 2009
Deflationary spirals
Dear readers,
We keep on digging in the deflation (D) versus inflation (I) theme as this will keep on dominating the debate for the foreseeable future. In our hunt for an I-D outcome in our last letter, we took a strong bias towards deflation. This week in our I-D series we share a few thoughts from Dr. De Grauwe, who was once on the short list to be nominated on the board of the ECB.
In our Tamiflate (July 2009) and Central Banker’s Paradox (Feb 2009) articles we already highlighted the task of a central bank and the Fed more in specific to inject extra inflation into the system in order to avoid a Dark Decade scenario like Japan. However we also explained at the time that expanding its balance sheet by asset purchases is not enough to influence the price level. Other parameters that might be out of reach of a central bank need also be influenced, i.e. the money multiplier must rise and/or the velocity of money must rise and/or the aggregate supply must show an upward sloping curve.
Remember this is captured in the simple equation GDP = M2 * V (see also Text book economics and keeping President Hoover in mind – April 2009) with M2 a measure for money supply and V representing the velocity of money.
We all know by know that none of these conditions are fulfilled. Personal income is still dropping, consumer spending is contracting due to the deleveraging process and the world will suffer for a very long time from overcapacity. Despite the fact that the new US jobs report last Friday accrued the camp of those who believe in a V-shaped recovery, we should warn for a false perception. The recovery we are seeing is first of all the result of government intervention and stock adjustments. And of that government intervention we can also argue that the only one that is having a significant impact is the one coming out of China. The US stimulus packages hardly make a difference. Once again this empirically proves the very low multiplicator effect of state aid to economic growth. In one of our earlier articles we also pointed out that for every USD spend by the government this would add maximum .3% to economic growth as far as the US is concerned. Furthermore the assumption that the US would lead the world back to growth would mean that the US consumer would return to his old habit of stretching his credit card like wet clay. We all know we are still in the midst of a deleveraging process, so this is not going to happen.
Bear also in mind, and this brings us immediately back to our topic of this week, deleveraging causes deflationary pressures.
Coming back to our equation we will show you why a central bank has limited impact on the money supply. Let’s argue that M2 = MB * m with MB the monetary base and m the money multiplier.
The money multiplier interacts with changes in time, Treasury deposit ratios and the currency. As a rule of thumb when Treasury deposit ratios or excess reserve ratios rise, the money multiplier drops. With the Fed now expanding its balance sheet like there is no tomorrow the excess reserves rise sharply, and as a consequence the money multiplier drops.
The excess reserves simply rose due to the fact that the Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed. We still see that a lot of banks park their liquidity at their corresponding central banks. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank's balance sheet. In the second quarter, excess reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). This is the reason that this money does not get recycled into the system. If it is parked at the Fed, ECB, BoE or BoJ it will not be used for investments or new loans issuance.
This is why commercial trade and industrial production fell of a cliff. Now productivity has been rebounding recently and on Tuesday it surprised on the upside, but there is a logical explanation for this. Labour costs have dropped at such a rapid pace as well. This explains why companies have been beating earnings estimates. Before the recession of 2001 productivity typically fell in recessions because companies waited too long to respond to the
downturn. Now, however, the pace of layoffs and the drop in hiring has been so quick and severe that productivity is up 1.8% y/y and unit labor costs are down 0.6%. Labor is the biggest cost by far for most businesses so if demand stabilizes while costs are falling, earnings improve. And the pressure on inflation eases too.
Four deflationary spirals
At this moment there are four deflationary spirals at work, i.e. the Keynesian savings paradox, Fisher’s debt deflation, the cost cutting deflation, and the bank credit deflation. Each of these deflationary spirals can be dealt with when they occur in isolation. However it becomes a dangerous cocktail when they are mixed together.
Keynesian savings paradox.
When one individual desires to save more, and he is alone to do so, his decision to save more (consume less) will not affect aggregate output. He will succeed to save more, and once he has achieved his desired level of savings he stops trying to save more.
When the desire to save more is the result of a collective lack of confidence ( our favorite animal spirits theme from Shiller) the individual tries to build up savings when all the others do the same. As a result, output and income decline and the individual fails in his attempt to increase savings. He will try again, thereby intensifying the decline in output, and failing again to build-up savings. There is thus a coordination failure: if the individuals could be convinced that their attempts to build up savings will not work when they all try to do it at the same time, they would stop trying, thereby stopping the downward spiral.
Somebody must organize the collective action. An individual agent will not do this because the cost of collective action exceeds his private gain.
Fisher’s debt deflation:
When one individual tries to reduce his debt, and he is alone to do so, this attempt will generally succeed. The reason is that his sales of assets to reduce his debt will not be felt by the others, and therefore will not affect the solvency of others. The individual will succeed in reducing his debt.
When the desire to reduce debt is driven by a collective movement of distrust, the simultaneous action of individuals to reduce their debt is self-defeating (Fisher(1933)). They all sell assets at the same time, thereby reducing the value of these assets. This leads to a deterioration of the solvency of everybody else, thereby forcing everybody to increase their attempts at reducing their debt by selling assets.
Here also there is a coordination failure. If individuals could be convinced that their attempts to reduce their debt will not work when they all try to do this at the same time, they would stop trying and the deflationary cycle would also stop. An individual, however, will have no incentive to organize such a collective action.
Cost cutting deflation
When one individual firm reduces its costs by reducing wages and firing workers in order to improve its profits, and this firm is alone to do so, it will generally succeed in improving its profits. The reason is that the cost cutting by an individual firm does not affect the other firms. The latter will not react by reducing their wages and firing their workers.
When cost cutting is inspired by a collective movement of fear about future profitability the simultaneous cost cutting will not restore profitability. The reason is that the workers who earn lower wages and the unemployed workers who have less (or no) disposable income will reduce their consumption and thus the output of all firms. This reduces profits of all firms. They will then continue to cut costs leading to further reductions of output and profits.
There is again a coordination failure. If firms could be convinced that the collective cost cutting will not improve profits they would stop cutting their costs. But individual firms have no incentives to do this.
This is not contradictory to what we have stated above. There we made the assumption that labour costs would drop in case of a stabilizing demand. In case of a deflationary environment demand will not stabilize but drop further as well and ultimately will effect the profitability of firms.
Bank credit deflation:
When one individual bank wants to reduce the riskiness of its loan portfolio it will cut back on loans and accumulate liquid assets. When the bank is alone to do so (and provided it is not too big), it will succeed in reducing the riskiness of its loan portfolio. The reason is that the strategy of the bank will not be felt by the other banks, which will not react. Once the bank has succeeded in reducing the riskiness of its loan portfolio it will stop calling back loans.
When banks are gripped by pessimism and extreme risk aversion the simultaneous reduction of bank loans by all banks will not reduce the risk of the banks’ loan portfolio. There are two reasons for this. First, banks lend to each other. As a result when banks reduce their lending they reduce the funding of other banks. The latter will be induced to reduce their lending, and thus the funding of other banks. Second, when one bank cuts back its loans, firms get into trouble. Some of these firms buy goods and services from other firms. As a result, these other firms also get into trouble and fail to repay their debt to other banks. The latter will see that their loan portfolio has become riskier. They will in turn reduce credit thereby increasing the riskiness of the loan portfolio of other banks.
There is again a coordination failure. If banks could be convinced that the simultaneous loan cutting does not reduce the risk of their loan portfolio they would stop cutting back on their loans and the negative spiral would stop. They have no individual incentives, however, to engage in collective action.
This reduction by bank loans got once again confirmed last month. According to the Wall Street Journal 13 out of 15 US banks cut back on their loan book in the second quarter. And the trend is continuing. Total bank credit contracted $41 billion (a 20% plunge at an annual rate!) for the week ending July 15. This was the fourth weekly decline in bank credit, totaling $94 billion. During the July 15th week, residential loans contracted $23 billion and have been down now for five of the past six weeks. Credit card outstandings fell $1.5 billion during the week (also a 20% annualized slide). Commercial & industrial loans dropped $1.7 billion — down over $50 billion in just the past three months or a 13% annual rate, which is unprecedented. It is worth highlighting that credit is the tint that makes the mare run — there is zero chance that the green shoots will amount to anything with bank credit in contraction mode as of mid-July, ironically the same month that so many pundits are pegging as the end of the recession.
Now coming back to the deflationary spirals that we described above, they all have the same structure. The actions by economic agents create a negative externality that makes these actions self-defeating. This spiral is triggered by a collective movement of fear, distrust or risk aversion ( once again we refer to animal spirits of Akerlof and Shiller(2009)). Individuals (savers, firms, banks) are unable to internalize these externalities because collective action is costly. As a consequence there is a failure to coordinate individual actions to avoid a bad outcome.
Cyclical movements in optimism and pessimism (animal spirits) have always existed. The question is though why exactly now they lead to such a breakdown of coordination? Paul De Grauwe makes a thorough analysis on this that we share in full text with you:
“The four deflationary spirals we identified, although similar in structure, are different in one particular dimension. The savings paradox and the cost deflation can be called “flow deflations”. They arise because consumers and firms want to change a flow (savings and profits). The other two involve the adjustment of stocks (the debt levels and the levels of credit). We call them “stock deflations”. Problems arise when the flow and stock deflations interact with each other.
In “normal” recessions such as the ones we have experienced in the postwar period prior to the present crisis, only the flow deflations were in operation. There had not been a preceding period of excessive debt accumulation and unsustainable levels of bank loans. As a result, households, firms and banks were not trying to adjust their balance sheets. The pessimism of households and firms was related to expected shortfalls in income and profits, and led to increased savings and cost cutting. In such an environment in which the stock levels were perceived to be right, there were sufficient automatic equilibrating mechanisms that prevented these two flow deflations from leading to an unstoppable downward spiral. The most important equilibrating mechanism occurred through the banking system.
When banks function normally they have a stabilizing force on the business cycle. The reason is that in a recession the central bank typically reduces the interest rate making it easier for banks to lend. In normal circumstances, when banks are not in the process of cleaning up their balance sheets, they will be willing to transmit this interest rate decline into a reduction of the loan rate. As a result, banks will engage in automatic “distress lending” to firms and households. Households will be less tempted to increase their savings. In addition, private investment by firms will be stimulated, i.e. firms will be willing to dissave, thereby mitigating the deflationary potential provoked by the savings paradox.” (In De Grauwe(2009) I show this in the context of a simple IS-LM analysis).
The interest rate decline will also mitigate the cost cutting dynamics. This is so because it improves the profit outlook for firms, giving them lower incentives to go on cutting costs. Thus when the banking system functions normally, there are self-equilibrating mechanisms that prevent the flow deflations from degenerating into uncontrollable downward spirals.
The problem the world economy faces today is that flow and stock deflations interact and reinforce each other. The period prior to the crisis was one of excessive buildups of private debt and banks’ assets. The result of these excessive buildups of private debt and balance sheets is that the stock deflation processes described in the previous section operate with full force. As a result, the equilibrating mechanism that exists in normal recessions does not function. The lower interest rates engineered by central banks are not transmitted by the banking sector into lower loan rates for consumers and firms. In addition, we now are confronted by the interaction of the flow and stock deflations. This interaction amplifies these deflationary processes. This interaction, which is especially strong in the US, can be described as follows. Because of excessive debt accumulation of the past, households desire to reduce their debt levels. Thus they all attempt to save more. As argued earlier, these attempts are self-defeating. As a result, households fail to save more, and thus fail to reduce their debt. This leads them to increase their attempts to save more. The fact that the banks do not pass on the lower deposit rates into lower loan rates makes things worse. There are no incentives for firms to increase their investments (no dissaving). Nothing stops the deflationary spiral.
The interaction goes further. The deteriorating conditions in the “real economy” feed back on the banking system. Banks’ loan portfolios deteriorate further as a result of increasing default rates. Banks reduce their lending even further, etc. In De Grauwe(2009) it is shown that a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
The irrelevance of modern macroeconomics
Modern macroeconomics as embodied in Dynamic Stochastic General Equilibrium models (DSGE) is based on the paradigm of the utility maximizing individual agent who understands the full complexity of the world. Since all individuals understand the same “Truth”, modern macroeconomics has taken the view that it suffices to model one “representative individual” to fully represent reality. Thus as a consumer the agent continuously maximizes an intertemporal utility function and is capable of computing the implications of exogenous shocks on his optimal consumption plan, taking full account of what these shocks will do to the plans of the producers. Similarly, producers compute the implications of these shocks on their present and future production plans taking into account how consumers react to these shocks. Thus in such a model coordination failures cannot arise. The representative agent fully internalizes the external effects of all his actions. When shocks occur there can be only one equilibrium to which the system will converge, and agents perfectly understand this (Woodford(2009)).
Deflationary spirals as we have described them in the previous sections cannot occur in the world of the DSGE-models. The latter is a world of stable equilibria. It will not come as a surprise that DSGE-models have not produced useful insight allowing us to understand the nature of the present economic crisis. Yet vast amounts of intellectual energies are still being spent on the further refining of DSGE-models.
Collective action to stop the deflationary spirals
The common characteristic of the different deflationary spirals is a coordination failure. The market fails to coordinate private actions towards an attractive collective outcome. This market failure can in principle be solved by collective action. Such a collective action can only be organized by the government. Let us analyze what this collective action must be to deal with the different forms of deflation.
The key to economic recovery is the stabilization of the banking sector. As argued earlier, a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
There is no secret about how the bank credit deflation can be stopped. Here are the principles (see Hall and Woodward(2009) for a more detailed analysis). First, bad loans should be separated from good loans, putting the former in separate entities (“bad banks”) to be managed by specialized management teams whose responsibility it is to dispose of these assets. Losses on these bad assets are inevitable, and so is the inevitability that the taxpayer will be asked to foot the bill.
The good loans remain on the balance sheet of the “good bank”. The hope is that this good bank, freed as it is from the toxic assets, will feel liberated and will be willing to take more risk so that the credit flow can start again. One can doubt, however, that a privately run good bank will have sufficient incentives to start lending again. The reason is that extreme risk aversion and a desire to “save the skin” of the shareholders will restrain the managers of the good bank in extending loans. If that is what the managers of the good bank do, the bank credit deflation process described earlier will not stop. This leads to the issue of whether it is not desirable to (temporarily) nationalize the good bank. Such nationalization would take away the paralyzing fear that new bank loans put the bank’s capital (and its shareholders) at risk.
There is a second reason why the government may want to temporarily nationalize the good bank. The bad bank – good bank solution carries the risk of socializing the losses while privatizing the profits. Indeed, the losses of the bad bank will necessarily be borne by the taxpayers. If the good bank remains in private ownership the expected future profits will be handed out to the shareholders. But these profits will be realized only because the toxic assets have been separated and the losses on these assets have been borne by taxpayers. It is therefore more reasonable to make sure that these future profits are given back to the taxpayers.
The resolution of the bank crisis along the lines discussed in the previous paragraphs is a necessary condition for the recovery. It will also make the use of other macroeconomic policies easier and more effective. These other macroeconomic policies must be geared towards resolving the other deflationary processes. Let us discuss these consecutively.
The Keynesian savings paradox
The collective action failure implicit in the Keynesian savings paradox calls for the government to do the opposite of what private agents do, i.e. to dissave. Dissaving by the government is a necessary condition for making it possible for private consumers to succeed in their attempts to save more.
A well-functioning banking sector reduces the need for dissaving by the government. When the banking sector works well, the consumers’ attempts to save more leads to a lower interest rate and induces firms to invest more (they dissave). As a result, the required dissaving by the government is reduced correspondingly.
Fisher’s debt deflation
Government action is required to solve the coordination failure implicit in the debt deflation process. This can be done by taking over private debt and substituting it with government debt. In doing so, the government makes it possible for the private sector to reduce its debt level. The private sector will then stop attempting (unsuccessfully) to reduce its debt level. The debt deflation process can stop.
The issue that arises here is whether the substitution of private by government debt will not lead to unsustainable government debt levels. There are two aspects to this issue. Let us first look at the debt levels of the public and private sectors in the euro zone. These are shown in figure 1. The most remarkable feature of this figure is how low the government debt is relative to private debt. In addition, the government debt is the only one that has declined (as a percent of GDP) during the last 10 years. This contrasts with the debt of households and especially the debt of financial institutions that has increased significantly and that stood at 250% of GDP in 2008. This is three times higher than the debt of the government which stood at approximately 70%. We conclude that more than the public debt, the private sector’s debt has become unsustainable. The process of substitution of private debt by public debt can go on for quite some time before it reaches the levels of unsustainability of the private debt.
Figure 1
Source: European Commission
The second dimension to the sustainability issue of government debt arises from the question of what will happen in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon. As a result, output and income are likely to go down further. This will negatively affect tax revenues and will increase future budget deficits, forcing governments to increase their debt. Refusing to stop the debt deflation dynamics by issuing government debt today will not prevent the government debt from increasing in the future. The same problem of sustainability of the government debt will reappear.
To conclude it is useful to formulate a methodological note. The effectiveness of fiscal policies has been very much analyzed by economists. It appears from the empirical evidence that fiscal policy is limited in its effect to boost the economy. This evidence, however, is typically obtained from equilibrium models estimated during “normal” business cycle movements (see e.g. Wieland(2009), Cogan, et al. (2009)). In the context of the flow and stock deflations that are disequilibrium phenomena and that at the core of the present economic downturn, fiscal policy becomes an instrument to stabilize an economy that otherwise can become unstable. This feature is absent from modern macroeconomic models that are intrinsically stable. The evidence obtained from these models may not be very relevant to gauge the effectiveness of fiscal policies in the present context.
References
Akerlof, G., and Shiller, R., (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press,
Cogan, J, Tobias, C, Taylor, J, and Wieland, V., (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009.
De Grauwe, P. (2009), Keynes’ Savings Paradox, Fisher’s Debt Deflation and the Banking Crisis, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Work_in_progress_Presentations/Flow-Stock%20Deflations.pdf
Fisher, I, (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, 1, October, pp. 337-57.
Hall, R., and Woodward, S., (2009), The right way to create a good bank and a bad bank, www.voxeu.org/index.php
Minsky, H., (1986), Stabilizing an Unstable Economy, McGraw Hill, 395pp.
Wieland, V., (2009), The fiscal stimulus debate: “Bone-headed” and “Neanderthal”? http://www.voxeu.org/index.php?q=node/3373
Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279
We keep on digging in the deflation (D) versus inflation (I) theme as this will keep on dominating the debate for the foreseeable future. In our hunt for an I-D outcome in our last letter, we took a strong bias towards deflation. This week in our I-D series we share a few thoughts from Dr. De Grauwe, who was once on the short list to be nominated on the board of the ECB.
In our Tamiflate (July 2009) and Central Banker’s Paradox (Feb 2009) articles we already highlighted the task of a central bank and the Fed more in specific to inject extra inflation into the system in order to avoid a Dark Decade scenario like Japan. However we also explained at the time that expanding its balance sheet by asset purchases is not enough to influence the price level. Other parameters that might be out of reach of a central bank need also be influenced, i.e. the money multiplier must rise and/or the velocity of money must rise and/or the aggregate supply must show an upward sloping curve.
Remember this is captured in the simple equation GDP = M2 * V (see also Text book economics and keeping President Hoover in mind – April 2009) with M2 a measure for money supply and V representing the velocity of money.
We all know by know that none of these conditions are fulfilled. Personal income is still dropping, consumer spending is contracting due to the deleveraging process and the world will suffer for a very long time from overcapacity. Despite the fact that the new US jobs report last Friday accrued the camp of those who believe in a V-shaped recovery, we should warn for a false perception. The recovery we are seeing is first of all the result of government intervention and stock adjustments. And of that government intervention we can also argue that the only one that is having a significant impact is the one coming out of China. The US stimulus packages hardly make a difference. Once again this empirically proves the very low multiplicator effect of state aid to economic growth. In one of our earlier articles we also pointed out that for every USD spend by the government this would add maximum .3% to economic growth as far as the US is concerned. Furthermore the assumption that the US would lead the world back to growth would mean that the US consumer would return to his old habit of stretching his credit card like wet clay. We all know we are still in the midst of a deleveraging process, so this is not going to happen.
Bear also in mind, and this brings us immediately back to our topic of this week, deleveraging causes deflationary pressures.
Coming back to our equation we will show you why a central bank has limited impact on the money supply. Let’s argue that M2 = MB * m with MB the monetary base and m the money multiplier.
The money multiplier interacts with changes in time, Treasury deposit ratios and the currency. As a rule of thumb when Treasury deposit ratios or excess reserve ratios rise, the money multiplier drops. With the Fed now expanding its balance sheet like there is no tomorrow the excess reserves rise sharply, and as a consequence the money multiplier drops.
The excess reserves simply rose due to the fact that the Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed. We still see that a lot of banks park their liquidity at their corresponding central banks. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank's balance sheet. In the second quarter, excess reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). This is the reason that this money does not get recycled into the system. If it is parked at the Fed, ECB, BoE or BoJ it will not be used for investments or new loans issuance.
This is why commercial trade and industrial production fell of a cliff. Now productivity has been rebounding recently and on Tuesday it surprised on the upside, but there is a logical explanation for this. Labour costs have dropped at such a rapid pace as well. This explains why companies have been beating earnings estimates. Before the recession of 2001 productivity typically fell in recessions because companies waited too long to respond to the
downturn. Now, however, the pace of layoffs and the drop in hiring has been so quick and severe that productivity is up 1.8% y/y and unit labor costs are down 0.6%. Labor is the biggest cost by far for most businesses so if demand stabilizes while costs are falling, earnings improve. And the pressure on inflation eases too.
Four deflationary spirals
At this moment there are four deflationary spirals at work, i.e. the Keynesian savings paradox, Fisher’s debt deflation, the cost cutting deflation, and the bank credit deflation. Each of these deflationary spirals can be dealt with when they occur in isolation. However it becomes a dangerous cocktail when they are mixed together.
Keynesian savings paradox.
When one individual desires to save more, and he is alone to do so, his decision to save more (consume less) will not affect aggregate output. He will succeed to save more, and once he has achieved his desired level of savings he stops trying to save more.
When the desire to save more is the result of a collective lack of confidence ( our favorite animal spirits theme from Shiller) the individual tries to build up savings when all the others do the same. As a result, output and income decline and the individual fails in his attempt to increase savings. He will try again, thereby intensifying the decline in output, and failing again to build-up savings. There is thus a coordination failure: if the individuals could be convinced that their attempts to build up savings will not work when they all try to do it at the same time, they would stop trying, thereby stopping the downward spiral.
Somebody must organize the collective action. An individual agent will not do this because the cost of collective action exceeds his private gain.
Fisher’s debt deflation:
When one individual tries to reduce his debt, and he is alone to do so, this attempt will generally succeed. The reason is that his sales of assets to reduce his debt will not be felt by the others, and therefore will not affect the solvency of others. The individual will succeed in reducing his debt.
When the desire to reduce debt is driven by a collective movement of distrust, the simultaneous action of individuals to reduce their debt is self-defeating (Fisher(1933)). They all sell assets at the same time, thereby reducing the value of these assets. This leads to a deterioration of the solvency of everybody else, thereby forcing everybody to increase their attempts at reducing their debt by selling assets.
Here also there is a coordination failure. If individuals could be convinced that their attempts to reduce their debt will not work when they all try to do this at the same time, they would stop trying and the deflationary cycle would also stop. An individual, however, will have no incentive to organize such a collective action.
Cost cutting deflation
When one individual firm reduces its costs by reducing wages and firing workers in order to improve its profits, and this firm is alone to do so, it will generally succeed in improving its profits. The reason is that the cost cutting by an individual firm does not affect the other firms. The latter will not react by reducing their wages and firing their workers.
When cost cutting is inspired by a collective movement of fear about future profitability the simultaneous cost cutting will not restore profitability. The reason is that the workers who earn lower wages and the unemployed workers who have less (or no) disposable income will reduce their consumption and thus the output of all firms. This reduces profits of all firms. They will then continue to cut costs leading to further reductions of output and profits.
There is again a coordination failure. If firms could be convinced that the collective cost cutting will not improve profits they would stop cutting their costs. But individual firms have no incentives to do this.
This is not contradictory to what we have stated above. There we made the assumption that labour costs would drop in case of a stabilizing demand. In case of a deflationary environment demand will not stabilize but drop further as well and ultimately will effect the profitability of firms.
Bank credit deflation:
When one individual bank wants to reduce the riskiness of its loan portfolio it will cut back on loans and accumulate liquid assets. When the bank is alone to do so (and provided it is not too big), it will succeed in reducing the riskiness of its loan portfolio. The reason is that the strategy of the bank will not be felt by the other banks, which will not react. Once the bank has succeeded in reducing the riskiness of its loan portfolio it will stop calling back loans.
When banks are gripped by pessimism and extreme risk aversion the simultaneous reduction of bank loans by all banks will not reduce the risk of the banks’ loan portfolio. There are two reasons for this. First, banks lend to each other. As a result when banks reduce their lending they reduce the funding of other banks. The latter will be induced to reduce their lending, and thus the funding of other banks. Second, when one bank cuts back its loans, firms get into trouble. Some of these firms buy goods and services from other firms. As a result, these other firms also get into trouble and fail to repay their debt to other banks. The latter will see that their loan portfolio has become riskier. They will in turn reduce credit thereby increasing the riskiness of the loan portfolio of other banks.
There is again a coordination failure. If banks could be convinced that the simultaneous loan cutting does not reduce the risk of their loan portfolio they would stop cutting back on their loans and the negative spiral would stop. They have no individual incentives, however, to engage in collective action.
This reduction by bank loans got once again confirmed last month. According to the Wall Street Journal 13 out of 15 US banks cut back on their loan book in the second quarter. And the trend is continuing. Total bank credit contracted $41 billion (a 20% plunge at an annual rate!) for the week ending July 15. This was the fourth weekly decline in bank credit, totaling $94 billion. During the July 15th week, residential loans contracted $23 billion and have been down now for five of the past six weeks. Credit card outstandings fell $1.5 billion during the week (also a 20% annualized slide). Commercial & industrial loans dropped $1.7 billion — down over $50 billion in just the past three months or a 13% annual rate, which is unprecedented. It is worth highlighting that credit is the tint that makes the mare run — there is zero chance that the green shoots will amount to anything with bank credit in contraction mode as of mid-July, ironically the same month that so many pundits are pegging as the end of the recession.
Now coming back to the deflationary spirals that we described above, they all have the same structure. The actions by economic agents create a negative externality that makes these actions self-defeating. This spiral is triggered by a collective movement of fear, distrust or risk aversion ( once again we refer to animal spirits of Akerlof and Shiller(2009)). Individuals (savers, firms, banks) are unable to internalize these externalities because collective action is costly. As a consequence there is a failure to coordinate individual actions to avoid a bad outcome.
Cyclical movements in optimism and pessimism (animal spirits) have always existed. The question is though why exactly now they lead to such a breakdown of coordination? Paul De Grauwe makes a thorough analysis on this that we share in full text with you:
“The four deflationary spirals we identified, although similar in structure, are different in one particular dimension. The savings paradox and the cost deflation can be called “flow deflations”. They arise because consumers and firms want to change a flow (savings and profits). The other two involve the adjustment of stocks (the debt levels and the levels of credit). We call them “stock deflations”. Problems arise when the flow and stock deflations interact with each other.
In “normal” recessions such as the ones we have experienced in the postwar period prior to the present crisis, only the flow deflations were in operation. There had not been a preceding period of excessive debt accumulation and unsustainable levels of bank loans. As a result, households, firms and banks were not trying to adjust their balance sheets. The pessimism of households and firms was related to expected shortfalls in income and profits, and led to increased savings and cost cutting. In such an environment in which the stock levels were perceived to be right, there were sufficient automatic equilibrating mechanisms that prevented these two flow deflations from leading to an unstoppable downward spiral. The most important equilibrating mechanism occurred through the banking system.
When banks function normally they have a stabilizing force on the business cycle. The reason is that in a recession the central bank typically reduces the interest rate making it easier for banks to lend. In normal circumstances, when banks are not in the process of cleaning up their balance sheets, they will be willing to transmit this interest rate decline into a reduction of the loan rate. As a result, banks will engage in automatic “distress lending” to firms and households. Households will be less tempted to increase their savings. In addition, private investment by firms will be stimulated, i.e. firms will be willing to dissave, thereby mitigating the deflationary potential provoked by the savings paradox.” (In De Grauwe(2009) I show this in the context of a simple IS-LM analysis).
The interest rate decline will also mitigate the cost cutting dynamics. This is so because it improves the profit outlook for firms, giving them lower incentives to go on cutting costs. Thus when the banking system functions normally, there are self-equilibrating mechanisms that prevent the flow deflations from degenerating into uncontrollable downward spirals.
The problem the world economy faces today is that flow and stock deflations interact and reinforce each other. The period prior to the crisis was one of excessive buildups of private debt and banks’ assets. The result of these excessive buildups of private debt and balance sheets is that the stock deflation processes described in the previous section operate with full force. As a result, the equilibrating mechanism that exists in normal recessions does not function. The lower interest rates engineered by central banks are not transmitted by the banking sector into lower loan rates for consumers and firms. In addition, we now are confronted by the interaction of the flow and stock deflations. This interaction amplifies these deflationary processes. This interaction, which is especially strong in the US, can be described as follows. Because of excessive debt accumulation of the past, households desire to reduce their debt levels. Thus they all attempt to save more. As argued earlier, these attempts are self-defeating. As a result, households fail to save more, and thus fail to reduce their debt. This leads them to increase their attempts to save more. The fact that the banks do not pass on the lower deposit rates into lower loan rates makes things worse. There are no incentives for firms to increase their investments (no dissaving). Nothing stops the deflationary spiral.
The interaction goes further. The deteriorating conditions in the “real economy” feed back on the banking system. Banks’ loan portfolios deteriorate further as a result of increasing default rates. Banks reduce their lending even further, etc. In De Grauwe(2009) it is shown that a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
The irrelevance of modern macroeconomics
Modern macroeconomics as embodied in Dynamic Stochastic General Equilibrium models (DSGE) is based on the paradigm of the utility maximizing individual agent who understands the full complexity of the world. Since all individuals understand the same “Truth”, modern macroeconomics has taken the view that it suffices to model one “representative individual” to fully represent reality. Thus as a consumer the agent continuously maximizes an intertemporal utility function and is capable of computing the implications of exogenous shocks on his optimal consumption plan, taking full account of what these shocks will do to the plans of the producers. Similarly, producers compute the implications of these shocks on their present and future production plans taking into account how consumers react to these shocks. Thus in such a model coordination failures cannot arise. The representative agent fully internalizes the external effects of all his actions. When shocks occur there can be only one equilibrium to which the system will converge, and agents perfectly understand this (Woodford(2009)).
Deflationary spirals as we have described them in the previous sections cannot occur in the world of the DSGE-models. The latter is a world of stable equilibria. It will not come as a surprise that DSGE-models have not produced useful insight allowing us to understand the nature of the present economic crisis. Yet vast amounts of intellectual energies are still being spent on the further refining of DSGE-models.
Collective action to stop the deflationary spirals
The common characteristic of the different deflationary spirals is a coordination failure. The market fails to coordinate private actions towards an attractive collective outcome. This market failure can in principle be solved by collective action. Such a collective action can only be organized by the government. Let us analyze what this collective action must be to deal with the different forms of deflation.
The key to economic recovery is the stabilization of the banking sector. As argued earlier, a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
There is no secret about how the bank credit deflation can be stopped. Here are the principles (see Hall and Woodward(2009) for a more detailed analysis). First, bad loans should be separated from good loans, putting the former in separate entities (“bad banks”) to be managed by specialized management teams whose responsibility it is to dispose of these assets. Losses on these bad assets are inevitable, and so is the inevitability that the taxpayer will be asked to foot the bill.
The good loans remain on the balance sheet of the “good bank”. The hope is that this good bank, freed as it is from the toxic assets, will feel liberated and will be willing to take more risk so that the credit flow can start again. One can doubt, however, that a privately run good bank will have sufficient incentives to start lending again. The reason is that extreme risk aversion and a desire to “save the skin” of the shareholders will restrain the managers of the good bank in extending loans. If that is what the managers of the good bank do, the bank credit deflation process described earlier will not stop. This leads to the issue of whether it is not desirable to (temporarily) nationalize the good bank. Such nationalization would take away the paralyzing fear that new bank loans put the bank’s capital (and its shareholders) at risk.
There is a second reason why the government may want to temporarily nationalize the good bank. The bad bank – good bank solution carries the risk of socializing the losses while privatizing the profits. Indeed, the losses of the bad bank will necessarily be borne by the taxpayers. If the good bank remains in private ownership the expected future profits will be handed out to the shareholders. But these profits will be realized only because the toxic assets have been separated and the losses on these assets have been borne by taxpayers. It is therefore more reasonable to make sure that these future profits are given back to the taxpayers.
The resolution of the bank crisis along the lines discussed in the previous paragraphs is a necessary condition for the recovery. It will also make the use of other macroeconomic policies easier and more effective. These other macroeconomic policies must be geared towards resolving the other deflationary processes. Let us discuss these consecutively.
The Keynesian savings paradox
The collective action failure implicit in the Keynesian savings paradox calls for the government to do the opposite of what private agents do, i.e. to dissave. Dissaving by the government is a necessary condition for making it possible for private consumers to succeed in their attempts to save more.
A well-functioning banking sector reduces the need for dissaving by the government. When the banking sector works well, the consumers’ attempts to save more leads to a lower interest rate and induces firms to invest more (they dissave). As a result, the required dissaving by the government is reduced correspondingly.
Fisher’s debt deflation
Government action is required to solve the coordination failure implicit in the debt deflation process. This can be done by taking over private debt and substituting it with government debt. In doing so, the government makes it possible for the private sector to reduce its debt level. The private sector will then stop attempting (unsuccessfully) to reduce its debt level. The debt deflation process can stop.
The issue that arises here is whether the substitution of private by government debt will not lead to unsustainable government debt levels. There are two aspects to this issue. Let us first look at the debt levels of the public and private sectors in the euro zone. These are shown in figure 1. The most remarkable feature of this figure is how low the government debt is relative to private debt. In addition, the government debt is the only one that has declined (as a percent of GDP) during the last 10 years. This contrasts with the debt of households and especially the debt of financial institutions that has increased significantly and that stood at 250% of GDP in 2008. This is three times higher than the debt of the government which stood at approximately 70%. We conclude that more than the public debt, the private sector’s debt has become unsustainable. The process of substitution of private debt by public debt can go on for quite some time before it reaches the levels of unsustainability of the private debt.
Figure 1
Source: European Commission
The second dimension to the sustainability issue of government debt arises from the question of what will happen in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon. As a result, output and income are likely to go down further. This will negatively affect tax revenues and will increase future budget deficits, forcing governments to increase their debt. Refusing to stop the debt deflation dynamics by issuing government debt today will not prevent the government debt from increasing in the future. The same problem of sustainability of the government debt will reappear.
To conclude it is useful to formulate a methodological note. The effectiveness of fiscal policies has been very much analyzed by economists. It appears from the empirical evidence that fiscal policy is limited in its effect to boost the economy. This evidence, however, is typically obtained from equilibrium models estimated during “normal” business cycle movements (see e.g. Wieland(2009), Cogan, et al. (2009)). In the context of the flow and stock deflations that are disequilibrium phenomena and that at the core of the present economic downturn, fiscal policy becomes an instrument to stabilize an economy that otherwise can become unstable. This feature is absent from modern macroeconomic models that are intrinsically stable. The evidence obtained from these models may not be very relevant to gauge the effectiveness of fiscal policies in the present context.
References
Akerlof, G., and Shiller, R., (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press,
Cogan, J, Tobias, C, Taylor, J, and Wieland, V., (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009.
De Grauwe, P. (2009), Keynes’ Savings Paradox, Fisher’s Debt Deflation and the Banking Crisis, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Work_in_progress_Presentations/Flow-Stock%20Deflations.pdf
Fisher, I, (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, 1, October, pp. 337-57.
Hall, R., and Woodward, S., (2009), The right way to create a good bank and a bad bank, www.voxeu.org/index.php
Minsky, H., (1986), Stabilizing an Unstable Economy, McGraw Hill, 395pp.
Wieland, V., (2009), The fiscal stimulus debate: “Bone-headed” and “Neanderthal”? http://www.voxeu.org/index.php?q=node/3373
Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279
Thursday 23 July 2009
Tamiflate: A strong medicine against deflation
Inflation versus deflation will be an infinitive ongoing academic debate. On several occasions we have pointed at the Federal Reserve’s balance sheet which has been expanded to unseen levels and simultaneously a US government which is creating a budget deficit which will soon go through the 100 % per GDP level.
When you are a classic monetarist you can only come to the conclusion this is going to ignite a serious inflation bubble in a couple of years from now. If you look at the logic that is used by the Australian Economic school there are arguments to be made this is a recipe for deflation seen in Japan, as foreign investors to flee both the dollar and Treasuries, driving up real interest rates, pole axing any revival in risk asset prices, themselves backed by the fruits of bubble-driven mal-investment.
Both schools have valid arguments, and that is why it is so difficult to choose a side in the debate and as a consequence tailor a policy on the back of the current issues. Certainly if the risk of a deflationary environment is being discussed, and Chairman Bernanke even repeated only this week in front of a Congress hearing Committee that deflationary risks are still present, the glooming picture of the Lost Decade in Japan shows up. However two highly reputed economists, Ben Bernanke himself and Paul Krugman, have developed a draft of a policy framework to solve the problem.
Paul Krugman’s paper in 1998 starts from the IS-LM curve in looking for an answer what Japan should have done to break through its deflationary cycle. He argues that when a central bank has brought its short term interest rates to zero, it will not be enough to start using the tool of quantitative easing to solve the liquidity trap. The reason for that is that from the moment, and this is very topical at this stage, that the markets believe that all this liquidity will be taken back somewhere in the future (for example central banks that are talking about exit strategies) the extra money that is printed right now will simply be parked on accounts and will not be spend. In this case the deflationary cycle remains intact.
In order to ignite spending behaviour a central bank should give a signal to the public that it will keep on printing money in the future rather than taking this money back. By doing this it will shift deflationary expectations to inflationary expectations. Or: “The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs." (1)
The way to achieve this would be by putting upfront an inflation target which is higher than the real (negative) inflation number at that moment. To get out of this liquidity trap the central bank needs to radically change expectations to the notion that there is no exit strategy, at least until inflation is appreciably higher – not just inflation expectations, but inflation itself. Only then would the commitment to higher inflation be credible, with the central bank not just talking the reflationary talk, but walking the reflationary walk, turning deflationary swamp water into reflationary wine.
This was Krugman’s advice towards the Bank of Japan in the late 1990s. Unfortunately they were not followed up by the central bank until in 2001 they applied his policy advice to a certain extent. In stead of setting an explicit higher inflation target it committed itself to a policy where they would continue with QE until year-over-year core CPI moved above zero on a "stable" basis. This is a light version of what Krugman initially recommended and it would still take five more years before the deflationary cycle was broken.
Then there is Mr. Bernanke who did extensive academic research on the issue of deflationary pressures and reflected his findings in one of his most important speeches in November 2002 “Making sure it doesn’t happen here.”
His idea was that the BoJ should set itself a price level target (PLT) in stead of an inflation target (IT). The difference is that IT does not define the future path of the price level. This can result in a costly uncertainty for the economy. PLT reduces the future price level uncertainty. The question remains though whether this would come at the expense of increased macro economic instability.
The major problem with IT is that it does not require a credible commitment to long-run stability in the price level. In practical terms, shocks to the price level under IT are simply accommodated and as a consequence not reversed. And uncertainty around price stability is a major concern for consumers when they enter in mortgages for example.
PLT takes this uncertainty away as the central bank in question explicitly commits itself to a certain price level target number. (2)
Mr Bernanke argues: “to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap. The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.
A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation." (3)
In this thesis Mr. Bernanke is counting on the communication skills from a/the central bank to create a clear difference between on the one hand a one-time re-flation to adjust a deflated price level back to levels in case there would not have been a deflationary cycle and on the other hand the central banks long term inflation target. Apart from the moral influence of a central bank to realise this perception change in the market he was also counting on a good interaction between the monetary and fiscal authorities to achieve this goal. Meaning one needs a government who is willing to apply a lose fiscal policy for a number of time together with a central bank who is willing to expand its balance sheet unlimited.
He continues: “My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.
Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but – because the BOJ purchased government debt in the amount of the tax cut – no current or future debt service burden has been created to imply increased future taxes.
Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about 'broken' channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.
Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.
Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ's purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations.
Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position." (4)
As far as the US concerns to a certain extend this is already happening. The Federal Reserve expanded its balance sheet considerable and the US Treasury is creating a mountain of debt (USD 1.8 trillion by the end of the year). The deflationary pressures at this moment are not yet that deep as was the case in Japan, but we are only the midst of the deleveraging process. As a result the US will stay in some sort of a liquidity trap for a while and will be the only party responsible for credit demand.
The question remains what will happen if the US consumer does not resume spending. In this case it is clear that Chairman Bernanke will be willing to go and use this extreme powerful tool. It will be like walking over thin ice and there is a possibility that the next generations will be paying a very high price for this (to the extent that we all are not already paying this), but the Fed Chairman made it clear in his title of his speech: "Making Sure 'It' Doesn't Happen Here" (5)
(1)"Japan's Trap," http://web.mit.edu/krugman/www/japtrap.html
(2) See also Donals Coletti and Rene Lalonde “Inflation targeting, Price level targeting and fluctuations in Canada’s terms of trade”, Central Bank of Canada, Winter 2007-2008
(3)http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
(4) See also Ben Bernanke, Essay “Japanese Monetary Policy: A Case of Self-Induced Paralysis." Princeton University, December 1999.
(5) The article is also inspired on thoughts from Paul McCulley, MD at Pimco
When you are a classic monetarist you can only come to the conclusion this is going to ignite a serious inflation bubble in a couple of years from now. If you look at the logic that is used by the Australian Economic school there are arguments to be made this is a recipe for deflation seen in Japan, as foreign investors to flee both the dollar and Treasuries, driving up real interest rates, pole axing any revival in risk asset prices, themselves backed by the fruits of bubble-driven mal-investment.
Both schools have valid arguments, and that is why it is so difficult to choose a side in the debate and as a consequence tailor a policy on the back of the current issues. Certainly if the risk of a deflationary environment is being discussed, and Chairman Bernanke even repeated only this week in front of a Congress hearing Committee that deflationary risks are still present, the glooming picture of the Lost Decade in Japan shows up. However two highly reputed economists, Ben Bernanke himself and Paul Krugman, have developed a draft of a policy framework to solve the problem.
Paul Krugman’s paper in 1998 starts from the IS-LM curve in looking for an answer what Japan should have done to break through its deflationary cycle. He argues that when a central bank has brought its short term interest rates to zero, it will not be enough to start using the tool of quantitative easing to solve the liquidity trap. The reason for that is that from the moment, and this is very topical at this stage, that the markets believe that all this liquidity will be taken back somewhere in the future (for example central banks that are talking about exit strategies) the extra money that is printed right now will simply be parked on accounts and will not be spend. In this case the deflationary cycle remains intact.
In order to ignite spending behaviour a central bank should give a signal to the public that it will keep on printing money in the future rather than taking this money back. By doing this it will shift deflationary expectations to inflationary expectations. Or: “The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs." (1)
The way to achieve this would be by putting upfront an inflation target which is higher than the real (negative) inflation number at that moment. To get out of this liquidity trap the central bank needs to radically change expectations to the notion that there is no exit strategy, at least until inflation is appreciably higher – not just inflation expectations, but inflation itself. Only then would the commitment to higher inflation be credible, with the central bank not just talking the reflationary talk, but walking the reflationary walk, turning deflationary swamp water into reflationary wine.
This was Krugman’s advice towards the Bank of Japan in the late 1990s. Unfortunately they were not followed up by the central bank until in 2001 they applied his policy advice to a certain extent. In stead of setting an explicit higher inflation target it committed itself to a policy where they would continue with QE until year-over-year core CPI moved above zero on a "stable" basis. This is a light version of what Krugman initially recommended and it would still take five more years before the deflationary cycle was broken.
Then there is Mr. Bernanke who did extensive academic research on the issue of deflationary pressures and reflected his findings in one of his most important speeches in November 2002 “Making sure it doesn’t happen here.”
His idea was that the BoJ should set itself a price level target (PLT) in stead of an inflation target (IT). The difference is that IT does not define the future path of the price level. This can result in a costly uncertainty for the economy. PLT reduces the future price level uncertainty. The question remains though whether this would come at the expense of increased macro economic instability.
The major problem with IT is that it does not require a credible commitment to long-run stability in the price level. In practical terms, shocks to the price level under IT are simply accommodated and as a consequence not reversed. And uncertainty around price stability is a major concern for consumers when they enter in mortgages for example.
PLT takes this uncertainty away as the central bank in question explicitly commits itself to a certain price level target number. (2)
Mr Bernanke argues: “to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap. The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.
A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation." (3)
In this thesis Mr. Bernanke is counting on the communication skills from a/the central bank to create a clear difference between on the one hand a one-time re-flation to adjust a deflated price level back to levels in case there would not have been a deflationary cycle and on the other hand the central banks long term inflation target. Apart from the moral influence of a central bank to realise this perception change in the market he was also counting on a good interaction between the monetary and fiscal authorities to achieve this goal. Meaning one needs a government who is willing to apply a lose fiscal policy for a number of time together with a central bank who is willing to expand its balance sheet unlimited.
He continues: “My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.
Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but – because the BOJ purchased government debt in the amount of the tax cut – no current or future debt service burden has been created to imply increased future taxes.
Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about 'broken' channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.
Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.
Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ's purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations.
Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position." (4)
As far as the US concerns to a certain extend this is already happening. The Federal Reserve expanded its balance sheet considerable and the US Treasury is creating a mountain of debt (USD 1.8 trillion by the end of the year). The deflationary pressures at this moment are not yet that deep as was the case in Japan, but we are only the midst of the deleveraging process. As a result the US will stay in some sort of a liquidity trap for a while and will be the only party responsible for credit demand.
The question remains what will happen if the US consumer does not resume spending. In this case it is clear that Chairman Bernanke will be willing to go and use this extreme powerful tool. It will be like walking over thin ice and there is a possibility that the next generations will be paying a very high price for this (to the extent that we all are not already paying this), but the Fed Chairman made it clear in his title of his speech: "Making Sure 'It' Doesn't Happen Here" (5)
(1)"Japan's Trap," http://web.mit.edu/krugman/www/japtrap.html
(2) See also Donals Coletti and Rene Lalonde “Inflation targeting, Price level targeting and fluctuations in Canada’s terms of trade”, Central Bank of Canada, Winter 2007-2008
(3)http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
(4) See also Ben Bernanke, Essay “Japanese Monetary Policy: A Case of Self-Induced Paralysis." Princeton University, December 1999.
(5) The article is also inspired on thoughts from Paul McCulley, MD at Pimco
Monday 13 July 2009
The Capitol Hill Baby sitting experiment
We have discussed the issues around deflation versus inflation already extensively in previous weekly reports. In this weekly we try to explain why recessions and the deflationary pressures that go hand in hand with them, take place. Then, we look at some data which can give some guidance whether deflation or inflation might win the debate in the foreseeable future.
Usually the best way to describe a certain system is to look at a model and see how it works on a micro level. One can compare it with model planes or cars being tested in a wind tunnel. In this case Nobel prize winner, Paul Krugman, explains the complex mechanics behind recessions and their deflationary pressures by referring to an example in history which is known as the Capitol Hill Baby-sitting Co-op.
This was a project, which started in the late 1950s, with the intention to give young families, who were living and working in Washington, a network of responsible, experienced adults to take on babysitting duties on a sit-for-sit basis. The experiment grew out to become a micro economy and would be highly representative in explaining how recessions take place and the pressure on prices it can have.
The project would work as follows:
Each member family is given a coupon – pieces of paper worth one half-hour of sitting time. That allowance is to be paid back within a year, in order to keep everyone sitting and everyone going out. A scheduling system is in place to organize sits each month, as well as a payment plan that includes time and a half for things like later hours.
In this system everything is based upon the belief that every couple goes out regularly and some others fit in to do baby-sitting. By doing so one part of the population could earn or save coupons which could be spent in turn when they decide to go out for an evening dinner.
However in the mid 1970s, the co-op experiment experienced something of a recession. There was a shortage of coupons, which led people to panic and hoard their shares. Because there was no regular circulation, the system was falling apart. When a rule requiring that couples go out at least once every six months ended up falling flat, the powers that be decided to create more coupons to alleviate the problem and encourage people to spend.
The shortage of coupons was created due to a lack of effective demand as households wanted to accumulate their cash (coupons). As is the case in a real economy the problem was located on the demand side and not on the supply side. Or in the words of the late Milton Friedman, too many people were chasing too few coupons.
In order to solve the problem the governing board of the co-op decided to put more coupons in circulation and the short term result was that couples were more willing to go out. This in turn created more opportunities to baby-sit, which in turn again stimulated young families to go out more regularly. In other words the vicious circle was broken by printing new coupons.
The latter is a text book recipe used by central banks to fight recessions; that is printing money.
In this respect one can wonder why for instance a nation like Japan could not get out of the deflationary spiral as the authorities used every tool available to break the vicious circle. They lowered short term rates to zero and kept them there for a considerable period of time. They did substantial amounts of quantitative easing. Last but not least there was public spending up to more than 170% of their GDP. None of the above was able to break the deflationary spiral.
Returning back to the micro economy of the baby-sitting co-op we can detect similarities. In order to get the system running again the governing board created the opportunity to borrow coupons and pay them back at a later stage with coupons earned from baby sitting. Of course to keep the system fair there was a penalty imposed where couples who borrowed coupons would have to pay an extra coupon back.
This gave the governing council a tool to boost demand, by changing the conditions of borrowing in times when demand was lagging. This is exactly what central banks are doing in general. However in the example of Japan interest rates were cut back to zero and nevertheless the economy did not kick back into gear.
The explanation for that: seasonal effects. Like in every economy, the baby-sitting co-op experiment experienced cyclical effects as well. Intuitively one can expect that couples were less motivated to go out during winter compared to the summer season. People would accumulate coupons for the summer when they would go out more frequently. When this seasonal phenomenon is not too strong the governing council could still make adjustments on the coupon borrowing in order that supply and demand returned to an equilibrium.
However it is perfectly possible when for example the winter would be very long and cold that even at no penalty to borrow coupons (zero interest rates) households would not be motivated to go out.
This is the situation where Japan has been in for the last 1.5 decades. Most probably due to demographic factors the Japanese population is not willing to spend anymore. An aging population is by definition more savings and less investing oriented. Furthermore an older society is more afraid for challenges of the future. This is why Japan’s economy will underperform significantly even with interest rates a zero.
This is what economists also call the liquidity trap.
The major reason Japan was/is stuck in a liquidity trap is due to the fact that the liquidity provided by the central bank was not passed on to the consumer or the industry. Banks used the extra liquidity to clean up their balance sheets. This is happening right now as well. One could argue, like Milton Friedman, that the solution to this problem would be that the central banks start lending directly to corporates and/or consumers. In theory this is possible, however central banks do not have the infrastructure to do this. Secondly this would not resolve the balance sheet problems of the banks either.
This is however the price one has to pay when a system built up excesses over many years and has to go through a deleveraging process. During this process the available credit is erased at a much faster pace than a central bank can print money. At this moment the amount of credit that is lost is approximately USD 14 tln versus USD 2 tln coming from the Fed and US government. This can be illustrated by looking at the gap between broad and narrow money (Figure 1). Broad money is reflected in M2. Narrow money is what the central bank is injecting into the system.
Figure 1 Broad versus narrow money
Source: John Mauldin OTB newsletter
Figure 1 describes the situation in the US however the picture is very similar in the Euro-zone and the UK.
As long as the gap remains very high it is unlikely that inflationary pressures will return. Even the argument that commodity prices sooner than later will automatically re-ignite inflationary pressures does not pass the test. This for the simple reason that commodity prices are inelastic. Elasticity is the degree to which a demand and supply curve reacts to a change in the underlying price of a product. In case a product is inelastic it means that it would be insensitive to price changes because the consumer has to buy it anyway even when the price would rise considerably.
Products such as oil and food are inelastic products. If prices would rise substantially people would look for alternatives to cut in their household budget. As a consequence demand for other products would fall and still create a deflationary environment.
Further taking into account that the industrial production apparatus is facing overcapacity (the aftermath of the excesses of cheap credit) and as a consequence a very weak labour market which keeps wages contained. This might be the ultimate reason why deflation is a much bigger threat than inflation right now, and for the next foreseeable future.
Usually the best way to describe a certain system is to look at a model and see how it works on a micro level. One can compare it with model planes or cars being tested in a wind tunnel. In this case Nobel prize winner, Paul Krugman, explains the complex mechanics behind recessions and their deflationary pressures by referring to an example in history which is known as the Capitol Hill Baby-sitting Co-op.
This was a project, which started in the late 1950s, with the intention to give young families, who were living and working in Washington, a network of responsible, experienced adults to take on babysitting duties on a sit-for-sit basis. The experiment grew out to become a micro economy and would be highly representative in explaining how recessions take place and the pressure on prices it can have.
The project would work as follows:
Each member family is given a coupon – pieces of paper worth one half-hour of sitting time. That allowance is to be paid back within a year, in order to keep everyone sitting and everyone going out. A scheduling system is in place to organize sits each month, as well as a payment plan that includes time and a half for things like later hours.
In this system everything is based upon the belief that every couple goes out regularly and some others fit in to do baby-sitting. By doing so one part of the population could earn or save coupons which could be spent in turn when they decide to go out for an evening dinner.
However in the mid 1970s, the co-op experiment experienced something of a recession. There was a shortage of coupons, which led people to panic and hoard their shares. Because there was no regular circulation, the system was falling apart. When a rule requiring that couples go out at least once every six months ended up falling flat, the powers that be decided to create more coupons to alleviate the problem and encourage people to spend.
The shortage of coupons was created due to a lack of effective demand as households wanted to accumulate their cash (coupons). As is the case in a real economy the problem was located on the demand side and not on the supply side. Or in the words of the late Milton Friedman, too many people were chasing too few coupons.
In order to solve the problem the governing board of the co-op decided to put more coupons in circulation and the short term result was that couples were more willing to go out. This in turn created more opportunities to baby-sit, which in turn again stimulated young families to go out more regularly. In other words the vicious circle was broken by printing new coupons.
The latter is a text book recipe used by central banks to fight recessions; that is printing money.
In this respect one can wonder why for instance a nation like Japan could not get out of the deflationary spiral as the authorities used every tool available to break the vicious circle. They lowered short term rates to zero and kept them there for a considerable period of time. They did substantial amounts of quantitative easing. Last but not least there was public spending up to more than 170% of their GDP. None of the above was able to break the deflationary spiral.
Returning back to the micro economy of the baby-sitting co-op we can detect similarities. In order to get the system running again the governing board created the opportunity to borrow coupons and pay them back at a later stage with coupons earned from baby sitting. Of course to keep the system fair there was a penalty imposed where couples who borrowed coupons would have to pay an extra coupon back.
This gave the governing council a tool to boost demand, by changing the conditions of borrowing in times when demand was lagging. This is exactly what central banks are doing in general. However in the example of Japan interest rates were cut back to zero and nevertheless the economy did not kick back into gear.
The explanation for that: seasonal effects. Like in every economy, the baby-sitting co-op experiment experienced cyclical effects as well. Intuitively one can expect that couples were less motivated to go out during winter compared to the summer season. People would accumulate coupons for the summer when they would go out more frequently. When this seasonal phenomenon is not too strong the governing council could still make adjustments on the coupon borrowing in order that supply and demand returned to an equilibrium.
However it is perfectly possible when for example the winter would be very long and cold that even at no penalty to borrow coupons (zero interest rates) households would not be motivated to go out.
This is the situation where Japan has been in for the last 1.5 decades. Most probably due to demographic factors the Japanese population is not willing to spend anymore. An aging population is by definition more savings and less investing oriented. Furthermore an older society is more afraid for challenges of the future. This is why Japan’s economy will underperform significantly even with interest rates a zero.
This is what economists also call the liquidity trap.
The major reason Japan was/is stuck in a liquidity trap is due to the fact that the liquidity provided by the central bank was not passed on to the consumer or the industry. Banks used the extra liquidity to clean up their balance sheets. This is happening right now as well. One could argue, like Milton Friedman, that the solution to this problem would be that the central banks start lending directly to corporates and/or consumers. In theory this is possible, however central banks do not have the infrastructure to do this. Secondly this would not resolve the balance sheet problems of the banks either.
This is however the price one has to pay when a system built up excesses over many years and has to go through a deleveraging process. During this process the available credit is erased at a much faster pace than a central bank can print money. At this moment the amount of credit that is lost is approximately USD 14 tln versus USD 2 tln coming from the Fed and US government. This can be illustrated by looking at the gap between broad and narrow money (Figure 1). Broad money is reflected in M2. Narrow money is what the central bank is injecting into the system.
Figure 1 Broad versus narrow money
Source: John Mauldin OTB newsletter
Figure 1 describes the situation in the US however the picture is very similar in the Euro-zone and the UK.
As long as the gap remains very high it is unlikely that inflationary pressures will return. Even the argument that commodity prices sooner than later will automatically re-ignite inflationary pressures does not pass the test. This for the simple reason that commodity prices are inelastic. Elasticity is the degree to which a demand and supply curve reacts to a change in the underlying price of a product. In case a product is inelastic it means that it would be insensitive to price changes because the consumer has to buy it anyway even when the price would rise considerably.
Products such as oil and food are inelastic products. If prices would rise substantially people would look for alternatives to cut in their household budget. As a consequence demand for other products would fall and still create a deflationary environment.
Further taking into account that the industrial production apparatus is facing overcapacity (the aftermath of the excesses of cheap credit) and as a consequence a very weak labour market which keeps wages contained. This might be the ultimate reason why deflation is a much bigger threat than inflation right now, and for the next foreseeable future.
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