Wednesday, December 19, 2007
krugman on the credit crunch
beginning with a general history dating back to the tech bust of 2000 and the flood of foreign capital that fueled (along with ratings agency complicity in accessing institutional capital pools) securitization -- including a debunking of 1998 comparisons (solvency, not liquidity) -- followed by a synopsis of what's been done (and not worked), including a dismissal of the paulson plan as insufficient ("worth a few billion") -- an effective dismissal of comparisons to the s&l crisis, as bad debts were then held by good depositors to the tune of $150bn, but bad debts are now held by "a lot of very undeserving investors" -- and what happens next.
krugman's guess sounds very similar to my own -- capital markets will remain crippled as asset deflation takes hold over the course of several years, with a window opened (in the q&a) to the 1930s.
but note this excellent theme from a dash of insight -- periods of extreme distress are often characterized by an increasing transparency of previously-opaque problems without a transparency of future solutions. it seems to me that we entered a phase of increasing transparency of problems and associated pessimism in july. so far, solution transparency has been very disappointing -- i've seen nothing in public policy that yet admits to the fact that this is a true banking solvency crisis, and until someone important does admit that we will go on implementing liquidity cures to the patient to little effect.
that may not last. there may be an attempt eventually at solvency cure -- a bank recapitalization. and that would be a start, perhaps, to solution transparency and a chance at optimism.
but it needs to be said that even solution transparency may be intrinsically disappointing. i recently had a gratifying exchange with stagflation mark, a frequent commenter at calculated risk and proprietor of illusion of prosperity in the comments here. his point of view on the direction of future events is in his name, but i think examining marc faber's figure 10 leads me to a different conclusion, a disorganized manifesto of which i can cut from the thread.
i would submit that, in accordance with irving fisher's theory of debt-deflation, the essential feature by which a recession becomes a debt-deflation is an initial condition of excessive debt.
as a percentage of gdp in the late 1960s, as seen on the chart, that condition simply did not exist on a scale equivalent to either 1929 or 2007. moreover, i suspect that if one could run that chart back to periods around 1814, 1836, 1865, 1892 -- years preceding the onset of deflationary periods -- one would see similar debt-to-gdp spikes waiting to be resolved.
... the more subtle point you're making, i think, is that the ease with which money supply can force credit expansion has improved so as to make infinite credit expansion possible. again, i just wonder.
the fed has a balance sheet to maintain which constricts eventually its ability to engage in lending programs like we have seen announced today.
and there are moreover limits to what it can do with its monetary monopoly. in the 1970s inflationary depression, the ratio of total money-plus-credit to m1 was about 11x. today, that ratio is closer to 40x. the government also in the 1970s governed the largest creditor nation on the planet; today, it governs the largest debtor nation -- and the difference is paramount.
i think the salient question is, "from that kind of ratio, can the fed print enough currency fast enough (from a policy-response viewpoint) to counteract a severe contraction in fractional reserve lending, i.e. a slowing in the velocity of money? and do so without forcing an international debt repudiation that would effectively decapitalize the american banking system by another path?"
i frankly don't think the policy response will be nearly fast enough to stave off the onset of deflation and put both borrowers and lenders into a debt-averse mindset. and even if they did, it would spark an international t-bond and agency debt repudiation that would force the american government into insolvency.
... the banks in japan (for example) needed balance sheet repair (ie, a way to reduce liabilities faster than assets were being written down), not balance sheet expansion (access to more cheap credit, which was more likely to further impair capital ratios in a falling asset price environment). the banks' attempt to do just that is why japan got credit contraction and deflation -- they let zero percent fund a relatively small carry income from foreign lending, which (along with incredible regulatory forbearance and periodic government treasury bailouts) slowly recapitalized them once asset price declines stopped destroying capital at a rate more rapid.
the result looked in japan like near-0% interest rates all the way out the curve, monetary base growing 25% a year, but m2+CDs growing at just 11% and bank credit declining year after year for a decade. even a recapitalization of the banks by government that amounted to 12% of gdp in 1999 did not break the domestic contraction, as it was merely held as a reserve against expected future asset price declines or lent out overseas.
in the united states, current credit levels were furthermore created in part by the shadow banking system of securitization -- including many institutionals and hedgies. these holders will not have access to fed funds or (very likely) rescue, and they won't have a way to recapitalize [via carry]. many will probably stop lending entirely, radically reducing the availability of credit.
in short, i suppose, nominal credit rates are not the same as credit availability. we have had a period of low nominal rates, negative real rates and incredible availability; that could well be followed by a period of zero nominal rates, high real rates and incredible unavailability.
... mab above discussed a fiscal response to private debt liquidation -- essentially the conversion of bad private credit into government credit, a wholesale recapitalizing of the system. i don't see this as likely -- outstanding government debt is in the area of $9tn now, and replacing a 20% contraction of [probable] private credit (taking m3 plus bank credit less m1 as a loose approximation, and hardly out of the realm of possibility from these heights) would
more thanapproximately double real government liability and amount to a bailout on the order of 300%75% of gdp. such a move or anything like it would probably force foreign treasury debt repudiation (imo) and quite possibly a dollar crash -- which would force a federal book balancing and cut the united states off from most of the imports it depends on for the orderly functioning of its society.
even if the capacity exists, this isn't something i think the united states is likely to hazard, dependent as it is on international trade for basic goods.
i think instead it will have to allow significant private credit contraction to progress while moderating it with whatever narrow-money-supply inflation it can get away with internationally, combined with cuts to extant spending plans such as medicare. as a large international debtor with a manufacturing base that has moved to china, it seems to me that it has little choice.
that would seem to me to imply general deflation of a kind seen perhaps not in 1929-1933 but in longer periods like that seen from 1865-1896.
... i think the health of the banking system is critical, as it is the vehicle of velocity and rising velocity is obviously necessary to hyperinflation as declining is to deflation. with banks in america now overextended and tightening lending standards to a public that is deeply indebted, coming off a period where velocity was very high and credit standards nearly nil, it's hard for me to see inflation as the likely next step even if the government starts increasing the monetary base as a stimulant.