Friday, November 16, 2007
goldman's economic call -- the great depression?
The slump in global credit markets may force banks, brokerages and hedge funds to cut lending by $2 trillion and trigger a ``substantial recession'' in the U.S., according to Goldman Sachs Group Inc.
Losses related to record home foreclosures using a ``back- of-the-envelope'' calculation may be as high as $400 billion for financial companies, Jan Hatzius, chief U.S. economist at Goldman in New York wrote in a report dated yesterday. The effects may be amplified tenfold as companies that borrowed to finance their investments scale back lending, the report said.
``The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,'' Hatzius wrote. ``It is easy to see how such a shock could produce a substantial recession'' or ``a long period of very sluggish growth,'' he wrote.
Goldman's forecast reduction in lending is equivalent to 7 percent of total U.S. household, corporate and government debt, hurting an economy already beset by the slowing housing market. Wells Fargo & Co. Chief Executive Officer John Stumpf said yesterday that the property market is the worst since the Great Depression.
Hatzius said his report is based on a ``conservative estimate'' of financial companies cutting lending by 10 times the loss to their capital. Investors realizing half of the potential losses, at $200 billion, would have to scale back lending by $2 trillion, he said.
``The response to those kinds of risks is to lower interest rates, and we think the Fed will lower interest rates,'' Hatzius said in an interview today. Goldman predicts a quarter-point cut when the Fed meets on Dec. 11.
If Goldman's forecast reduction in lending occurs over a single year, the U.S. economy could fall into recession, Hatzius wrote. The drop in lending over two to four years would probably result in ``very sluggish growth,'' he said.
Deutsche Bank AG, Germany's biggest bank, also said in a report this week that credit losses may be $400 billion. That's equivalent to ``one bad day in the stock market,'' or 2.5 percent of the value of U.S. equities, Hatzius wrote.
``No serious analyst would argue that a 2.5 percent equity market decline will make an important difference to the economic outlook,'' Hatzius wrote. ``So what's different about the mortgage credit losses? In a word, leverage.''
a lot of people have missed the point entirely on the housing problem by looking at the potential loan losses, comparing them to the size of the economy and concluding that there is no problem. what makes the housing decline so disastrous is the borrowing that is predicated on the loans -- the leverage in the system that is anchored to housing is the proverbial onion, with layer upon layer all facing an unexpected unwind.
hatzius is being generous at $2tn -- i would expect considerably more credit contraction than that, in the area of $5tn or more IF the system remains stable and no major banks or GSEs fail outright.
that would be something on the order of 10% of the american credit/money supply pie.
for context, in the great depression, monetary measures like m2 collapsed in excess of 30%. there is a question here of how bad this could be. this overview of the great depression expounds on the credit theory of the depression, which is that explored by irving fisher in his seminal 1933 "debt-deflation theory of great depressions" and furthered by ben bernanke in 1983.
Bernanke (1983) argues that the monetary hypothesis: (i) is not a complete explanation of the link between the financial sector and aggregate output in the 1930s; (ii) does not explain how it was that decreases in the money supply caused output to keep falling over many years, especially since it is widely believed that changes in the money supply only change prices and other nominal economic values in the long run, not real economic values like output ; and (iii) is quantitatively insufficient to explain the depth of the decline in output. Bernanke (1983) not only resurrected and sharpened Fisher’s (1933) debt deflation hypothesis, but also made further contributions to what has come to be known as the nonmonetary/financial hypothesis.
Bernanke (1983), building on the monetary hypothesis of Friedman and Schwartz (1963), presents an alternative interpretation of the way in which the financial crises may have affected output. The argument involves both the effects of debt deflation and the impact that bank panics had on the ability of financial markets to efficiently allocate funds from lenders to borrowers. These nonmonetary/financial theories hold that events in financial markets other than shocks to the money supply can help to account for the paths of output and prices during the Great Depression.
Fisher (1933) asserted that the dominant forces that account for “great” depressions are (nominal) over-indebtedness and deflation. Specifically, he argued that real debt burdens were substantially increased when there were dramatic declines in the price level and nominal incomes. The combination of deflation, falling nominal income and increasing real debt burdens led to debtor insolvency, lowered aggregate demand, and thereby contributed to a continuing decline in the price level and thus further increases in the real burden of debt.
Bernanke (1983), in what is now called the “credit view,” provided additional details to help explain Fisher’s debt deflation hypothesis. He argued that in normal circumstances, an initial decline in prices merely reallocates wealth from debtors to creditors, such as banks. Usually, such wealth redistributions are minor in magnitude and have no first-order impact on the economy. However, in the face of large shocks, deflation in the prices of assets forfeited to banks by debtor bankruptcies leads to a decline in the nominal value of assets on bank balance sheets. For a given value of bank liabilities, also denominated in nominal terms, this deterioration in bank assets threatens insolvency. As banks reallocate away from loans to safer government securities, some borrowers, particularly small ones, are unable to obtain funds, often at any price. Further, if this reallocation is long-lived, the shortage of credit for these borrowers helps to explain the persistence of the downturn. As the disappearance of bank financing forces lower expenditure plans, aggregate demand declines, which again contributes to the downward deflationary spiral. For debt deflation to be operative, it is necessary to demonstrate that there was a substantial build-up of debt prior to the onset of the Depression and that the deflation of the 1930s was at least partially unanticipated at medium- and long-term horizons at the time that the debt was being incurred. Both of these conditions appear to have been in place (Fackler and Parker, 2001; Hamilton, 1992; Evans and Wachtel, 1993).
In addition, the financial panics which occurred hindered the credit allocation mechanism. Bernanke (1983) explains that the process of credit intermediation requires substantial information gathering and non-trivial market-making activities. The financial disruptions of 1930–33 are correctly viewed as substantial impediments to the performance of these services and thus impaired the efficient allocation of credit between lenders and borrowers. That is, financial panics and debtor and business bankruptcies resulted in a increase in the real cost of credit intermediation. As the cost of credit intermediation increased, sources of credit for many borrowers (especially households, farmers and small firms) became expensive or even unobtainable at any price. This tightening of credit put downward pressure on aggregate demand and helped turn the recession of 1929–30 into the Great Depression. The empirical support for the validity of the nonmonetary/financial hypothesis during the Depression is substantial (Bernanke, 1983; Fackler and Parker, 1994, 2001; Hamilton, 1987, 1992), although support for the “credit view” for the transmission mechanism of monetary policy in post-World War II economic activity is substantially weaker. In combination, considering the preponderance of empirical results and historical simulations contained in the economic literature, the monetary hypothesis and the nonmonetary/financial hypothesis go a substantial distance toward accounting for the economic experiences of the United States during the Great Depression.
from the start of the great depression, net private debt (fig 15) fell about 18% in nominal terms -- and it is important to realize that this means a contraction in money supply in the broadest sense, as debt is credit and credit is akin to money. in the first few years, that broad money supply contraction actually outpaced the actual nominal debt payoff -- such that (fig 16) REAL net private debt increased even as NOMINAL net private debt decreased. this is because the first people to pay down private debt were the banks, and the money multiplying effect of fractional reserve banking ran in reverse. as credit became impossible to get, gross domestic product collapsed, meaning that real debt as a percentage of gdp (fig 17) jumped some 60% between 1929 and 1933.
this is a very similar situation to what we face today. as hatzius noted, banks are looking at monstrous writeoffs and will be forced to contract credit -- that is, the broadest measure of money supply. that credit/money contraction, coming at a time of such high levels of general indebtedness across the economy, will force the level of real net private debt higher very quickly and compel a sharp fall in economic activity -- particularly if, that is, the federal reserve bank does not fairly radically expand narrow money supply and recapitalize banks either by steepening the yield curve sharply or simply giving balance sheet relief to the major banks.
what separates recession from depression in my opinion is this: broad money supply contraction actually outpaced the actual nominal debt payoff -- such that REAL net private debt increased even as NOMINAL net private debt decreased. one tries to raise capital ratio by selling assets, but prices mark down so quickly under even modest selling pressure that the losses incurred on remaining assets outsize the capital raised by the sale. in the event, trying to repair the aggregate national balance sheet actually and paradoxically destroys the balance sheet. this can only occur when there are huge numbers of sellers and almost no buyers, beginning from a level of very high indebtedness. and that's exactly what the banks are facing in the market for residential mortgage-backed securities and CDOs, to the extent that they are liquid at all.
UPDATE: having dug up my copy of fisher's 1933 article and charts, chart v shows the decline in national wealth from 1929 to 1933 as $362bn to $150bn nominal ($270bn in 1929 dollars) -- that's a 25% decline in real wealth.
this earlier post references the potential of an $8tn decline (with the weight of dean baker's opinion) on a $45tn tangible asset base -- a 17% decline, and this of course before taking into account other aspects of the weakening american credit picture, such as commercial real estate. i hesitate to add this as this is not strictly apples to apples -- national wealth in this case should encompass not only consumer durables and real estate but net financial equity as well. but it does provide some sense of the scale of the problems the united states is now facing. it seems to me that it's a potentially embarrassing understatement to say that these are larger problems than were seen in 1990.
UPDATE: via calculated risk, some discussion about the scale of equity losses among homeowners -- particularly how it hasn't started showing up yet because ofheo house price indexes are still in the process of nosing over.