An odd sign of the times, or perhaps specifically, of financial stress; reversals of position. Today we have Citigroup, which previously stated it wouldn’t take SIV assets on to their balance sheet, relenting and doing just that. The Fed makes a few hawkish noises but still delivers a rate cut. Henry Paulson, a believer in the lightly regulated form of capitalism, going through some interesting feats of legerdemain to present the Treasury’s various shore-up-the-markets initiatives as private sector efforts (in detail perhaps, but not in conception or spirit).
George Magnus, the bearish UBS economist who is looking more prescient with every passing day, is perhaps best known for popularizing the concept of a “Minsky Moment.” By way of background, economist Hyman Minsky observed that creditors become more lax about lending standards during times of stability. He divided borrowers into three types: the upstanding sort that can pay principal and interest; speculative borrowers (or “units”), who can pay interest but have to keep rolling the principal into new loans; and “Ponzi units” which can’t even cover the interest, but keep things going by selling assets and/or borrowing more and using the proceeds to pay the initial lender. Minsky’s comment:
Over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight of units engaged in speculative and Ponzi finance.
What happens? As growth continues, central banks become more concerned about inflation and start to tighten monetary policy,
…speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently units with cash flow shortfalls will be forced to try to make positions by selling out positions. That is likely to lead to a collapse of asset values.
Now Magnus appears to have changed positions via his comment in the Financial Times, “Monetary policy is out of sync.” In fairness, I don’t have access to his research and thus depend on sightings of them in the media, and he also appears (wisely) to have steered clear of policy prescriptions until recently. His shift is subtle rather than overt.
Nevertheless, if you believe the root of our current financial problem is seriously overvalued assets that were driven into the stratosphere by the jet fuel of leverage, there isn’t an easy solution. The too-richly-priced investments have to come down in price. Parties who lent too much against collateral will likely take losses, either in a visible way or by having their principal balances eroded by inflation. This is a pick-your-poison sort of problem.
So it’s odd to read someone as perceptive as Magnus arguing for rate cuts. Not that there isn’t a case to be made for them, but it needs to acknowledge the costs, and Magnus chooses to dismiss them instead. He focuses on core inflation, when the non-core elements have been unidirectional (as opposed to merely volatile, the reason for not including them). Moreover, the five year forward rate is signaling that inflationary expectations are rising, and the central bank’s big worry is that inflationary expectations become embedded. Indeed, if you take the view that inflation is 3%, a Fed fund rate of 4.25% means there is very little room before we get to zero real interest rates.
There are some interesting statements, nevertheless, that explain Magnus’ call for action. His eyepopping comment is that a World Bank study estimates that we are in the midst of the biggest banking crisis since the 1970s, and their initial loss estimates put the damage from this implosion on a par with the collapse of the Japanese bubble economy in the early 1990s. That news would tend to focus the mind.
We’ve seen a more obvious change in posture from another far-sighted bear, Nouriel Roubini. Roubini has been the source of the observation that the credit crisis is the result of problems of insolvency and lack of transparency. Earlier he argued monetary measures would not suffice, and fiscal programs were necessary. Yet he too of late has been calling for deeper rate cuts. What gives? Both Magnus and Roubini acknowledge that more liberal application of monetary stimulus is unlikely to drive funds to the parts of the market that are frozen, yet they still call for interest rate reductions.
I can only hazard a guess as to what is at work. Some of it is that central bankers have very few tools at their disposal. The best remedies are probably regulatory changes, but those take time to implement, and the situation is devolving rapidly, or at least so it seems.
But I think there is a deeper issue at work. Too many observers want to believe that there is a solution. My sense is the best we have is palliatives. We can either take the losses, as the US has repeatedly told third world countries in similar fixes to ours, or we can go the Japan route of socializing the cost of propping up bad businesses and deals, or we can expand the money supply considerably and let inflation eat away at the value of the debt overhang. These are at least choices, but I don’t see anyone (meaning any policy maker) discussing them explicitly. Instead, we are getting ad hoc pieces of each, depending who is screaming loudest at whom at the moment.
And the root problem? Too many people are looking to the Fed for answers, and this problem is much bigger than the Fed, I don’t mean in terms of its complexity, but simply the size and firepower the Fed has. (By happenstance of timing, Paul Krugman comes to the same conclusion, although he works through the issues differently).
In 1980, the Federal Reserve System was roughly twice as large as Chase Manhattan Ban. As of late June, the Fed’s total assets were $871 billion, and its total capital was $33 billion. At that time, Citigroup’s’ total assets were $2.22 trillion and its shareholder’s equity was $128 billion. So not only is the Fed a much less powerful actor in comparison to other bank, but also financial intermediation has moved substantially away from bank and into capital markets. Faith in the Fed’s power, at least in intervening in markets, seems very much misplaced. Oddly, it potentially has far more authority as a regulator, but thinking along those lines has fallen badly out of favor.
From the Financial Times:
Occasionally, there is an unreal moment on television when the movement of the speaker’s lips bears no relation to what you hear. Something very similar is happening as regards the conduct of monetary policy in the downswing of the global credit cycle.
What you can hear is a legitimate expression of concerns by central bankers and some economists about easing monetary policy too fast or at all. But it is out of “synch” with the script, so to speak, which is about something quite different, namely the banking crisis. The early cost estimates approximate those of the Japanese banking crisis in the early 1990s and overshadow any of the other 112 banking crises since 1970, according to a study by the World Bank.
The first argument advanced for caution is that after the exceptional housing boom, prices should be allowed to fall back towards more reasonable levels. But there is little risk that lower interest rates would arrest the adjustment of prices. Up to 60 per cent of the variation in house prices is thought to arise from supply, regulations and inventory, rather than from macro-economic factors. Rising repossessions are occurring before the economy has slowed down significantly. The US proposal to freeze mortgage rates for subprime borrowers misses the point that most repossessions happen because of unemployment or income constraint, not interest payment adjustment.
The moral hazard argument – to avoid rescuing risk-takers for fear of encourager les autres – is of course an important tenet of monetary policy but there comes a point when democratic societies have to simply cast it aside. We have reached that point. The capital of the banking system is under significant pressure but banks can deal with this, as they can with a decaying credit cycle. The financial system can deal also with market liquidity problems, more limited transactions volume and wider margins between buy and sell rates. What the financial system cannot deal with properly is a drying up of funding liquidity, reflected in exceptionally high interbank rates and the interactions between both types of constrained liquidity. The longer this continues, the greater are the systemic and economic risks.
To address the particular problem of high interbank rates out to three months and beyond, the Federal Reserve announced in midweek that it would provide $40bn of credit and activate $24bn of currency swap arrangements with other central banks to make dollars available. The proposed credit measures are like those pursued by the European Central Bank, but with little success; they probably will not help much on their own. Banks can absorb liquidity but if solvency issues prevent them from wanting to lend on, funding rates are simply going to remain high and sticky. That said, the status quo was not tenable either.
Inflation risk is perhaps the main economic concern for central banks and investors. But whatever the inflation risks in the next few years, it seems unreal to worry about backward-looking food and energy price rises when a nasty deflationary credit crisis is just starting. No banking crisis has ever been followed by rising inflation (except the mid-1970s when oil prices quintupled). Core inflation in most countries remains tame and there has been little pass-through of prices from headline to core rates. Thanks mainly to globalisation, wage rises and pricing power remain subdued. As output growth slows in developed countries, commodity prices are likely to drop.
Unusually expansive credit conditions are reversing. They were associated with extreme changes in consumption behaviour, reflected in the sharp fall in personal savings in the US, UK and other countries and in China’s fixed investment boom. As household spending and savings adjust over the coming year and unemployment rises, the risk of higher cyclical inflation seems tiny enough to ignore.
As monetary policy must be forward-looking, it is appropriate to ease monetary conditions pre-emptively. This will not stop house prices and collateral values from falling. It can help, at the margin, to rebuild confidence and liquidity in the functioning of financial markets. It is most unlikely to be compromised by rising inflation. No one knows how bad the credit and housing cycle will get but because of that, better to act now and change policy again later, if needs be, than to recite good but flawed monetary policy mantras that are out of “synch” with what was going on in the economy. This too is a lesson from the Japanese crisis.