I appreciate your added comments today and that type of dynamic interaction (from you), once in awhile is helpful in sparking new ideas or all of us poor blogging surfers.

I wanted to also add that any debate of economics always seems to have built in lag periods where information is digested and then used as a basis for whats next.

Thus we often hear that Fed rate cuts are not felt for six months or so, which in my mind makes the current panic to cut, and cut more deeply somewhat suspect and an over-reaction as to how much stimulus is needed to save us all from ruin — so as to allow more walmarts to be built and more McMansions to spread like wildfire as in an out-of-control pandemic.

The point being, where is the recognition of reality that there are cyclical periods of expansion and times where sustained hyper-growth are not realistic? We have just seen a massive amount of never before seen global collusion where derivatives have been packaged and linked to every possible asset in the world that could be consolidated into daytrade/monetized vehicles that are based entirely on illusionary financial engineering mechanics!

Some governments will elect to fight credit contractions with ballooning deficit spending. The resulting spike in real interest rates, caused by “crowding out”, only makes the problem worse. The ball lands in the Central Bank’s court: finance the deficits to bring down real interest rates, or accept record unemployment. More often than not, Central Banks opt for the former. There are literally dozens of examples of this occurring, most notably in Latin America.

There is but one example in recent history of the opposite being true: in Japan, the Central Bank never faced the choice of deficit financing. Unlike EVERY other country, Japanese savers were glad to finance their government’s deficit. No capital flight, no flight from the banking system, and a sky-high savings rate were all unique features of Japanese deflation.

So basically, it comes down to two things:

Will the U.S. government use the Central Bank to finance spending?

Will U.S. savers keep their money here, or send it abroad?

I also agree (and have said repeatedly) that there will be sustained credit contraction. The level of credit relative to GDP has risen to ridiculous and unsustainable levels.

What bothers me most about the debate in the media and Washington is the lack of interest in regulatory reforms. Thanks to Reagan and Milton Friedman, we have an intellectually incoherent faith in free markets. Now if by free markets you mean “a system by which pricing rather than central planning is the main/preferred mechanism for resource allocation” no one would disagree with that as a good concept. But that high level abstraction has been taken way way beyond its optimal form to be equated to “regulation in any form is bad.” And that is just nuts.

My buddy Amar Bhide (Harvard then Columbia B School prof) wrote a very important and largely ignored paper in which he pointed out that the market that most people liked to cite as an example of a successful, well functioning market, the stock market, was in fact heavily regulated. Never before was something as ambiguous as a stock traded on an anonymous, arm’s length basis for sustained periods of time (previous efforts all wound up with large-scale fraud and collapse). But we may need another collapse (I hope not) to shake the prevailing ideology.

E. Cartman,

Good question (yours of 11:39 AM). The classic fear re deflation is that of a so-called liquidity trap. Consumers have no incentive to spend because goods will be cheaper, and no incentive to save because interest rates are too low. People hold and hoard cash.

Now if you think about it, that may not make as much sense as it seems to. People need to eat, buy gas and laundry detergent whether prices are falling or not. Cell phones, computers, and consumer electronics are subject to marked deflation, yet people buy them avidly (of course, they have been clever in also creating forced obsolescence and short product lives). The US had mild deflation for much of the 19th century.

Similarly, the Japanese have had high savings rates despite near zero yields (of course, their government has allowed banks to provide retail products to enable them to chase higher yields overseas). But that is party due to poor social safety nets in Japan, greater job insecurity, and frankly, teeny houses (how much can you spend on stuff if you have no place to put it?)

I have long thought that the telling of the Depression story placed too much emphasis on monetary policy and too little on institutional failure. The fact is, as Paul Krugman pointed out, the Fed DID increase the monetary base, which is the one thing they control directly. Money supply nevertheless fell because people pulled cash out of banks. And that was completely rational because banks were failing (my maternal grandfather got 3 cents on the dollar he had deposited).

In the modern world, unless we have massive bank collapses, people would not keep their money in mattresses. And in a deflationary environment, you’d probably see a pretty flat yield curve, so there wouldn’t be much risk in maturity transformation.

Don,

Agreed that the emphasis among the powers that be on restoring/maintaining confidence is likely overdone. However, what we just saw at year end was a crisis in confidence in the form of banks unwilling to lend to each other. That was mainly due to lack of transparency. No one knew how badly damaged anyone else was, and they were hoarding liquidity for themselves because they were concerned that a failure or further impairment would lead to a worsening of the seize up.

Now the TAP and other measures actually worked, at least for the moment. So the monetary authorities now have an example of one of their finesses addressing a problem of information AND confidence.

Further, I believe these “con” measures are directed at the stock market, even though that is NOT the Fed’s job. Greenspan took way way too much interest in the general level of stock prices, and saw them as validation of his policies. My impression is that his world view has infected the Fed. And if you believe Martin Wolf, stock prices globally even at current levels are well above long-term historical averages. It has been remarkable how the stock market has kept shrugging off, until recently, the bad news from the credit markets.

The problem of low US wages is a known unknown, because we haven’t seen a cycle in which the power of labor has been broken.

(Note to elites: be careful what you wish for.)

If we have inflation, in a cycle of falling or stagnant wages and rising unemployment, the economy contracts further. It will contract and contract until the demand for those commodities shrinks.

So, if inflation in commodities takes hold, the eventual size of the economy at which the contraction stops is smaller than it would be if there were no inflation.

My main interest is how almost 8 years of excessive, unregulated, over-stimulated assets bubble building can be sustained in any way, shape or form, which is why a fiscal stimulus plan is tantamount to insanity — like holding a can of gas over the BBQ and trying to get the grill hot enough for burgers! If our lenders and governments would have faced up to the reality of abusing the housing market to offset the cost of the war in Iraq, we would have seen Fed rates closer to 8% a long time ago, to slow down excess speculation and to curb the bubble…..but noooo (as Belushi would scream) we had people in control that wanted more growth at any cost, but now as that cost is being examined, how do they want to solve it all…more gas on the BBQ, more stupidity and a lack of control in an endless exercise of retardation!

Im thinking our economy will be in a hell of a lot of trouble, if we dont get a Paul Volker attitude very soon: olcker’s Fed is widely credited with ending the United States’ stagflation crisis of the 1970s by limiting the growth of the money supply, abandoning the previous policy of targeting interest rates. Inflation, which peaked at 13.5% in 1981, was successfully lowered to 3.2% by 1983.

Also, I have to paste this somewhere today, so thanks in advance: Ambac said on Friday it had scrapped plans to issue $1 billion of new equity, in a move that may result in the bond insurer’s top debt ratings getting cut.

The planned equity issuance was meant to shore up Ambac’s balance sheet as securities linked to mortgages and other consumer debt suffer from unexpectedly high losses.

Markets now feared Ambac’s warning note was a signal other insurers could also be hurt on their massive bond portfolios.

Paul

Confidence collapses *for a reason.* It doesn’t just spontaneously crumble. It’s sadly hilarious that Mishkin takes such a dumb perspective.

Those of us willing to question the “wisdom” of the financial elites have profited handsomely from this latest mess, by buying gold, or shorting subprime, or similar such maneuvers. The investors who have lost their shirts are the morons who keep telling themselves that the financial elites have “contained” the “crisis in confidence.”

“Crisis of confidence” is itself a nice little orwellian twist. It has such temporary connotations, as if a little tinkering by the high priests of the printing press will see it through in no time.

The huge quantities of bad debt must be flushed from the system. Despite anti-market engineering on the part of the Fed, Treasury, and FHLBs, it will still happen soon. The only way the government could really keep the curdled debt on the books for the pernicious long term would be by bailing out MBIA and Ambac, which would be a disaster for the dollar.

I ask again: what is so bad about deflation? In a vacuum, obviously, deflation is undesireable. But we aren’t in a vacuum, and there is a widely held sense among consumers that the national savings cushion is far too low. Deflation is the antidote to a negative real savings rate.

Obviously, credit hyperdeflation is bad, but some credit deflation is necessary. It will also, if it is allowed to happen, overwhelm rising price inflation.

However, with the Fed trending towards 75 to 100 basis points’ worth of cuts on Jan 30, there’s little prospect of real credit deflation taking place until real return on Treasuries is in the -5 percent range. Stagflation is a lot closer than people think, if it isn’t here already.

The emphasis on confidence is like chasing one’s tail . . . one just runs in circles. Why? Because an emphasis on a crisis of confidence doesn’t explain what lies at the root of the crisis . . . of confidence. Its dealing with effect rather than cause, giving attention to consequences rather than getting to the core of the crisis. The important matter is . . . why the lack of confidence in the first place, not that there is a lack of confidence.

And this takes us to engineer. Restoring confidence appears not so much a matter of correcting the cause for the crisis in confidence as it is a matter of restoring the belief that the cause has been corrected, or is in the process of being corrected, and thus also the belief in the capability of the Fed to do so. The implications being that if enough believe then it will happen.

Thus the drift more and more to psychology, to a engineering of public relations, a marketing campaign aimed at restoring confidence which is expected to lead to correcting the cause of the crisis. Again, chasing one’s tail, for it seems to me that it isn’t a matter of changing minds or attitudes or beliefs that needs addressing but rather getting to the root causes in the first place, one which I consider to be more systemic than generally acknowledged.

I am not suggesting that the socio-psychological sphere be ignored. Instead, I’m suggesting that the emphasis given to it (and the magical effects expected from it: inflationists), is symptomatic of the deeper problem. Attempts at confidence building (whether by Bernanke, Paulsen, Bush or Congress) have turned to crisis management . . . as a substitute for getting to the root of the problem, one for which they are not capable of doing for it runs deeper than individuals and even that of institutions.