I'm a believer in two things when it comes to monetary policy. First, it is in the best interests of everyone that long-term inflation remains contained. Therefore the Fed should be primarily focused on inflation most of the time.
Second, debt deflation is extremely dangerous for modern economies. I believe (and Ben Bernanke believes) this is what caused the Great Depression, and if we were to experience another Depression, debt deflation is the likely culprit.
The current housing market could cause a debt deflation-type event. Falling housing prices put mortgage holders in an increasingly negative net worth position. It could spiral out of control: bank failures, credit unavailable, etc. Do I think this is a high probability event? No. But it could happen.
This is why I support continued Fed cuts. Does it make sense that the Dow would fall 300 points just because the Fed cut 25 instead of 50? Perhaps not. I mean, the Fed could cut 50bps at their next meeting and accomplish the same result. So I don't think the 25bps cut today indicates the Fed is behind the curve or that they are ignoring the risks I've discussed above.
But we do need continued liquidity from the Fed to ensure that the debt deflation scenario doesn't come to pass. If the result is a little extra inflation down the road, so be it.
Look for the Fed to continue cutting until its clear the debt deflation risk has passed.
25 comments:
I think they did their job: they made a cut instead of keeping rates steady.
So, the market sell-off today is a bit silly.
Although these machinations are basically true to form for the FED, scared to death of asset deflation as they are and remembering the helicopter is warmed up, I think once the unemployment starts to blow out of control, the average person won't be thinking about his next borrowing, it'll be survival at all costs and debt won't be one of them. The Depression had 8% and we're only at a moderate 4.7%.
the problem today was that statement. what was it? it smacked of indeciveness and i think thats what stocks keyed on.
as mr. miyagi said "walk on right side of road, safe; walk on left side of road, safe; walk in middle of road, get squished, just like grape"
Cutting Fed Funds interest rate is not going to cut it. Fix Libor!
It's silly to think that the Fed can either:
a.) control interest rates. They don't and can't - they are more or less following LIBOR and other large market forces. They may try to defend a certain rate but that is about the best they can hope for. The kindness of strangers (foreign central banks) wanes with both agencies and treasuries (no real activity in seven weeks) and fictitious capital is getting destroyed by the tens of billions each week.
b.) save asset bubble with lower interest rates. You describe debt deflation in a very nonchalant manner as if some minor tweaking of the interest rates by the Fed can "save" numerous speculators and asset bubbles from the folly of their excesses. Nothing could be further from the truth. RE was (and is) in a monstrous financial mania, completely disconnected from the underlying cash flow fundamentals. Now that the psychology of this historic credit bubble has turned, cascading cross-defaults are the inevitable outcome, as well as much lower asset prices. This was unavoidable as Greenscam lowered rates too far and kept them there too long, and then encouraged irresponsible lending practices with his "ARM's for everyone" world tour.
Liquidity and solvency are two totally different issues and don't confuse the two. Although I totally agree with you that debt deflation is extremely dangerous and I believe the vicious cycle of total debt liquidation has begun and will lead directly to GD2. Nothing can be done about this and Bernanke was hired specifically because he is the foremost GD authority and he will guide us as well as anyone can through this absurdity.
Everything is proceeding as I have foreseen.
Usually, when I read through comments, I ignore personal webpages referred to by the comment author.
Well, there's an exception in these comments.
rajesh's comment directs you to his webpage where he talks about LIBOR. He is dead right. It's worth a read.
http://rraut1.livejournal.com/2007/12/11/
The risk is bank failures. Banks start failing and society will break down.
Fix Libor!
"But we do need continued liquidity from the Fed"[AI]
With FHLB supporting the current home overvaluations with $746bn in 3Q 2007 ("up from practically nothing in the second quarter."), you want more?
Look, for all I know, back in August when you informed us For anything housing related, forget it. There are no bids. it was because everybody who could bid knew they couldn't compete with the higher bids FHLB system offered.
Quickly on debt deflation:
I'm not saying the Fed can bail out home owners who over extended. I'm saying they can prevent a real disaster scenario. That's all. Make it so that nominal home losses stay in the 10% area rather than the 20% area.
I'll make some other comments later.
"Make it so that nominal home losses stay in the 10% area rather than the 20% area."[AI]
Using a 3.8X multiple at present, even your 20% implies a median home price to median income (inflation-adjusted) multiple of greater'n 3x. I will read with intense attention any comments you generously provide showing how that is, in any way, sustainable, much less a multiple higher'n 3.4x (your 10% loss scenario).
Well the Fed didn't fix LIBOR, but this new liquidity facility has potential to fix LIBOR where the Fed wants it.
Psycho: I'm writing a post on home price values that will be out this week. I'd love to comment more indepth about your multiple theory. What source are you using for home values and income? (Just so our numbers match)
"What source are you using for home values and income?"[AI]
My Personal Favorite Summary of the whole mess, and adding some hyperbole and sarcasm all my very own.
I just take a quick glance at this graph and sigh.
1) My Dad taught me to restrict myself to home purchases = 1xAnnual Income
2) Before I graduated from college, the multiple had already increased beyond 2.2x
3) Now a 3x multiple is too low to achieve, if any of your recommendations are adopted.
Toro cited this WSJ link for the graph.
"I'm writing a post on home price values that will be out this week."[AI]
I don't read you regularly thinking I know more than you. I read you regularly so I can fix the mistakes and misconceptions resulting from my knowing less than you.
Psycho: The whole point of the blog, for me, is to get better at what I'm doing. I was working on a home price model and I'm not terribly satisfied with my results so far. So I'm on the look out for alternative means to get to the end.
Hopefully everyone views this as a blog where you can disagree with the author and yet the conversation remains civil. That's what AI is all about.
See: iTulip, Bart, 12/11
"Inflation versus deflation debate for Red Pill consumers"
(1) Graph: SOMA holdings (13 week r-o-c).
"The job of the Federal Reserve is to take away the punch-bowl just when the party starts getting interesting"... William McChesney Martin, Jr.
The "punch-bowel is empty.
"The risk is bank failures. Banks start failing and society will break down."
Yes, but what is the alternative? If you don't allow banks to fail and mark assets to market, you get in a situation where you have bunch of zombie banks that are so saddled with debt that they can't lend. Either way, the result is the same. The Fed can't "save" the banking system, this is a myth. If you look at the hundreds of trillions in fictitious capital that has been created by Wall St. wildcat ponzi finance and the fractional reserve sweeps system, and then you look at the Fed's paltry $700B reserves, you begin to understand the magnitude of the deception.
Darker, the coming storm grows.
love the starwars refences.....
“If you strike me down, I should become more powerful than you could possibly imagine.”
I’m sympathetic to your desire to avoid debt deflation, but like psychodave, I think the enormous distortions in home price appreciation relative to income (and rents as well) may leave few other choices. The Fed’s use of the housing bubble as a remedy for the dotcom excesses is the largest policy mistake the Fed has made since the Great Depression. The well known wage suppressing effects of globalization are precisely the dangerous counterpart to wide participation, heavily leveraged asset inflation, resulting in a toxic mixture of excessive debt loads, low interest rates and poor debt service ability. With a sufficiently booming global economy driving the cost of commodities and basic materials higher, already heavily indebted home owners are trapped in a mire of growing expenses and liabilities and stagnant wages.
Even if house price depreciation can be stopped at 10%, who will take the buy side in the transactions without a promise of appreciation? The carrying and transaction costs of real estate ownership are very high, especially at today’s extremely inflated price levels. One look at Shiller’s historical house price graph should have taken the Fed’s breath away. Without an assurance of substantial HPA, even with all the extreme tax incentives, homeownership is simply vastly more expensive than renting. Who can prudently afford to buy inflated property (without teaser rates, without large and unwise debt to income ratios, in other words without some of the very dangerous poison pumping through the financial system now)? Who wants a home that doesn’t already have one in an economy glutted with an oversupply of residential development?
The housing bubble may have resuscitated a dotcom drowning economy threatened with deflation but only at an enormous price. The Fed, ironically, has created a situation where the only way to restore something resembling ordinary supply demand and prudent financial behavior is with debt deflation, bankruptcies (corporate, municipal and individual), foreclosures, unemployment and economic contraction, or, as the only viable alternative I see, is price controls, wage controls and nationalization of the mortgage industry. It seems that the lessons of the twentieth century, contrary to popular contention, were not learned at all. The Fed’s defeat of the dotcom deflation has created something much more virulent and pernicious.
Accrued- -Are you serious????
Now we're into unexplored territory here (het, this IS economics!). BUT:
The Fed lowers. Foreign investors can get better safe returns elsewhere; say, 5.5% - 6.5%. Why send money here to finance that ever increasing trade deficit and federal debt? Instead, they sell US bonds to get rid of depreciating assets. US interest rates skyrocket. Since savers want positive returns, retailers and manufacturers have to sell for more. Inflation skyrockets. WHAT DEFLATION???
What have I got wrong?
Now a falling US$ does make US exports cheaper- -it's a way of fighting a trade war by other means. But some other nations have noticed and are also devaluing their currency. A race to the bottom may also loom.
OK guys. You can't dismiss the case of debt deflation on one hand, but then express fear over falling housing prices.
This liquidationist idea that bad borrowers need to be punished was tried... in 1929. It didn't work then, and won't work now.
But forget all that. Ben Bernanke is one of the world's foremost researchers on the Depression. And he believes it was caused by debt deflation. So he won't allow that to happen now. Line up your market bets accordingly. If you think cutting rates is a mistake, buy TIPs. But don't ignore the plain fact that Bernanke will do everything in his power to avoid debt deflation.
As for the dollar. Who cares? The dollar has lost over 25% over the last 5 years, and over 35% since its recent peak. Where's the inflation? The evidence is that there is no inflation pass-through, or its very low. So why are we worried about the dollar?
People like Krugman argue that foreign investors will one day "wake up" and stop buying U.S. investments. Maybe they will. But what are they waiting for?
"This liquidationist idea that bad borrowers need to be punished was tried... in 1929. It didn't work then, and won't work now."
Yes, and usually result in the exact opposite of what "free market capitalists" want - more gov't intervention. Hence the FDIC, SEC, NASD, Social Security, minimum wage, etc, etc, etc...
A solid, quick read on Bernanke/depression is Ben's speech at Milton Friedman's 90th b'day.
"OK guys. You can't dismiss the case of debt deflation on one hand, but then express fear over falling housing prices."[AI]
I don't "fear" falling housing prices. I think they'd be real good for the country.
I fear the combination of government intervention and the massive (mis)allocation of capital by the private sector it would take to sustain median housing price at more than 3x median household annual income.
I'm a renter, but still don't support punishing bad borrowers.
I do share FormerlyknownasJS's estimate that to keep bad lending's head above water will require "price controls, wage controls and nationalization of the mortgage industry".
I'm one of those that lost over 50% in 2000 2001 in stocks. It is much better for everybody that now we're paying 14 - 17x multiples for the S&P 500, not 30x. Bringing housing prices down to 2.5x to 3x median income is not the crisis deflation of the Great Depression.
I think the new TAF is cuter'n a puppy. It sure beats lowering the Fed Funds Rate. I also like the collateral terms.
You keep saying "Liquidity". This post says 60-day AA nonfinancial yield is 4.18%. That's low.
Even institutions that shouldn't be trusted with anybody's money only have to pay 5.80% (see 60-day AA asset-backed yield in cited post).
I still see no Liquidity Crisis.
Accrued- -Listen
http://financenews1.blogspot.com/2007/12/bernanke-may-risk-fool-in-shower-label.html?referer=sphere_related_content
That is what you face. Also, I know of no law that says you cannot have deflation in some itms in a market and inflation in others. You COULD have housing deflation and gas, groceries, .... inflation at the same time. In fact, in classic inflation, precisely that happens: the cost of labor falls while other costs rise.
Bernanke is an expert on the Depression? You and I both know there are more theories about what happened and why between 199 and 1939 than there are economists. Try this:
http://www.amazon.com/Forgotten-Man-History-Great-Depression/dp/0066211700/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1197579265&sr=1-1
It makes a lot of sense and gives quite a different picture than I believe you have heard till now. Your library may have it.
"As for the dollar. Who cares?"
Again,are you serious? What do you buy that is not imported or contain imported parts? Do you know that lettuce in your salad probably came from Mexico?
" The dollar has lost over 25% over the last 5 years, and over 35% since its recent peak. Where's the inflation? The evidence is that there is no inflation pass-through, or its very low. So why are we worried about the dollar?"
http://www.crbtrader.com/crbindex/
The PPI, CPI, and other inflation gauges computed by the government are weifgted baskets and leave much rom for mischief. The gov't has good reason to want a low inflation number: TIPS, SS COLA, and politics. I suggest a more balanced view is needed.
"People like Krugman argue that foreign investors will one day "wake up" and stop buying U.S. investments. Maybe they will. But what are they waiting for?"
They've already started. Part of it is that fall of the dollar. Foreign gov't are griping about having to keep a depreciating asset (the US$) to buy oil and because it's the international reserve currency.
This isn’t about punishing bad borrowers. This is about having market prices and a sound economy. I don’t want an official source telling me how much I can sell my house for and how much I need to pay for the house down the street (P>X-.1X). Let the market set prices, a price level will be found and everyone knows it. Too much of the oft lamented illiquidity is in fact terrified interests that have bet the wrong way and stand to lose everything. There is an abundance of capital, it simply does not want to buy overpriced assets, and those with the overpriced assets have taken to calling this “illiquidity,” something it clearly is not. Thus we have the spectacle of insolvency masquerading as a liquidity crisis.
The great danger is that rather than having a market based adjustment we will have a government sponsored zombie financial infrastructure with no sense of supply, demand, investment or reasonable allocation of resources at all. The housing bubble is really just consumption on steroids, the glorified atrophy of an unproductive culture. What can we produce with all these houses other than bogus debt and junk credit for the street to play with? Sure it juiced the economy after the dotcom debacle, but again, I say, at what price?
The point is that this housing bubble, and it is enormous by many measures, is economically unsound. It is current consumption of a very expensive heavily leveraged good at the expense of the rest of the economy and future growth. Retaining this debt as a chain around the neck of the economy to fight the ghost of the Great Depression, while seeming like a sound move, is in fact the opposite. It will insure that Americans devote their income to debt service, that future generations don the same yoke, that rather than embracing the progress of technological, scientific and industrial innovation Americans will toil to preserve the bottom line of shoddy bankers, incompetent pension fund managers and talentless capitalists.
A good central banker will see this entanglement and watch for the linchpins, carefully insuring that key institutions survive, insuring that reasonably priced credit is available when needed, while letting the bloated financial sphere and reckless credit expansion deflate so that real economic activity can grow in its place. This is not a call for a Mellonesque liquidation. This is a call for common sense, a call for investment, production and prudent financial arrangements rather than rabid consumption and mindless debt expansion. The housing bubble must be allowed to follow the rationale of market prices, not put on life-support.
Sure there will be losses, and yes it will hurt, and maybe we’ll all have to work harder and consume less, but perpetuating an intoxicated fantasy pumped up on cheap credit is not the solution. I’m all for supplementing a market solution to a complex set of problems with a carefully crafted plan, but cultivating a society of sharecroppers is not it.
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