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Monday, August 04, 2008


'to risk the end of a civil society'

peter bernstein is a historian of markets. as such, his comfortable knowledge of past events should lead him to circumspect views of current events. which is why people should listen when -- in the pages of the new york times, no less -- he can say:

Today, a halt in the decline of home prices seems the necessary condition to transform the system from despair to hope and to turn the financial sector, now embattled and disorganized, back into the functioning organism the economy needs so badly. Indeed, here is where economic policy can have some influence on the outcome. ...

These steps would involve more effort by Washington — including financial incentives — to persuade mortgage lenders to be patient about repayments instead of foreclosing and making matters worse. After all, every participant in the mortgage business will breathe more easily when the decline in home prices comes to an end.

Assistance to individuals and institutions in trouble always raises concerns about the moral hazards of bailouts, especially when a case can be made that people underrated risks or were blindsided in their decision-making. But we have no choice here. The economy teeters on the edge of not just a recession, but also a more profound decline where trouble in any single sector can spread breakdowns throughout the system, driving unemployment to intolerable levels. To sit back and let nature take its course is to risk the end of a civil society.

Until we move more decisively in this direction, other efforts are likely to be frustrating at best and counterproductive at worst. The household is the key to the puzzle.

to this moment, i think the vast majority considerably underestimates the downside possibility of what is transpiring in the capital markets.

bernstein, however, clearly does not.

all the more's the pity, then, that the policy measures bernstein implies (as does bill gross) but does not articulate to support housing prices at levels current or even nearby simply do not exist. clive crook in the financial times says as much, noting the growing commodity inflation problem.

What more can be done? The short answer is nothing. The policy options have narrowed almost to zero. The Federal Reserve has already cut interest rates sharply – more than some think wise – and is having to assure the markets that it is keeping an eye on inflation. In spite of the slowdown, consumer prices are rising at their fastest for almost 20 years. Crucially, this has not embedded itself in expectations of permanently higher inflation. If that happens, and prices start pushing wages, interest rates would have to go up. The recent poor numbers for output and jobs led markets not to expect that interest rates will be cut further, but to hope that they will not be raised again just yet.

Some fiscal room for manoeuvre would be good right now – but precious little remains. The White House just updated its budget forecasts for next year. These pencil in a deficit of nearly $500bn (£253bn, €321bn). This excludes roughly $80bn of war costs. It also makes incomplete allowance for the fiscal component of the various housing-related bail-outs now in train. If Freddie Mac and Fannie Mae, the housing agencies, are forced to draw on the full support that the Treasury, with the passage of the new housing bill, is empowered to provide, add tens of billions more. A deficit of 5 per cent of gross domestic product next year is within reach.

... If the budget outlook starts to scare the markets and interrupt the flow of foreign capital to the US, the dollar might fall abruptly – worsening the inflation risk and forcing the Fed’s hand on interest rates. The point at which fiscal easing becomes self-cancelling may not be far away.

paul krugman would seem to agree.

What more can policy do? The Fed has pretty much used up its ammunition ... And nothing much can or should be done to support home prices, which are still much too high in inflation-adjusted terms. Nor can Washington prevent a continuing credit crunch: overextended, undercapitalized financial institutions have to rein in their lending, and it’s not realistic to expect the public sector to pick up all the slack — especially when quasipublic institutions like Fannie and Freddie are also in trouble.

and they aren't the bears, a moniker that might fit meredith whitney better. (i might note that being criticized vociferously by tom brown probably enhances her credibility.)

instead, per paul davis:

Too many developed economies got addicted to asset inflation - the increasing valuations were the only source of yield to service the debt incurred in their purchase - a Ponzi scheme in the Minsky sense. Now that bubble has burst. Houses are a non-productive asset, a consumption good. Values have to fall to where they can be serviced from current incomes - whether via a mortgage payment or rent - or incomes have got to rise via wage inflation. I still don't see any other way out. The first decimates (many) banks, the second decimates the dollar.

robert shiller thinks a "new new deal" is justified while talking highmindedly of the power of depression to force positive systemic change, but does not address the dollar-crisis aspect of financing such a program.

the result ends up a bust, and one that -- as doug noland relates -- is climbing the social ladder and expanding its geographic reach.

The subprime mortgage fiasco provides a convenient poster child for this boom’s egregious excesses. I would argue, however, that its role in fueling the boom was much less than presumed. ... I tend to view subprime as chiefly a “lower end” issue with respect to the real economy. And it is my view that the greatest – as well as least appreciated – Bubble Economy Excesses were at The “Upper-middle” to “Upper-end.” It is in The Upper-ends where years of Credit excess had the most pronounced effects on incomes, household net-worth, spending, and government revenues.

It was the at The “Uppers” where loose finance encouraged many to stretch to buy the expensive home, to lease the luxury vehicle, and to finance the upscale lifestyle – Credit creation that then further stoked the overall economy and asset markets. And it was the Uppers that enjoyed spectacular gains in income and financial wealth. It was the momentous changes in Uppers’ spending patterns that spurred enormous real economy investments in a multitude of new businesses and services – a great deal of this spending of the discretionary and luxury variety. It was the Uppers’ windfalls that encouraged state, local and federal governments to rapidly boost spending. These were the inflationary distortions that had a profound impact on the underlying economic structure – over years spurring the transformation to a “services”-based Bubble Economy.

It is my view that The Uppers are now in the process of being hit with rapidly tightening Financial Conditions. ... major “white collar” job losses ... significant tightening of Credit Availability ... Leasing terms are now being tightened significantly ... higher rates and additional withdrawal from the Jumbo mortgage marketplace ... broad-based downturn in housing prices will spur a more broad-based decline in spending – especially for discretionary purchases by The Uppers.

Increasingly, the post-boom adjustment in spending patterns is challenging the profitability of scores of businesses. This dynamic is poised to feed on itself, as more business closures and layoffs severely impinge incomes. And what I expect to be rapidly deteriorating business Credit conditions will surely worsen the financial crisis.

... With business and economic prospects now deteriorating rapidly, I would expect significant tumult to unfold in the corporate Credit market. And a reversal of speculative flows away from leveraged business lending would be a major blow to both corporate Credit Availability and the vulnerable leveraged speculating community, a dynamic with negative ramifications for the Uppers.

And when it comes to states with huge exposure to Uppers, California and New York sit at the top of the list. Not surprisingly, both states are today in the grips of intense fiscal pressure. And with my expectation that economic prospects are now worsening by the week, it is not at all clear how California, New York and other states will deal with ballooning deficits. Drastic spending cuts and tax increases are inevitable to get budgets back somewhat in line with post-boom receipts. ...

i'm increasingly of the mind that what may decide whether this downturn plays out as a relatively severe recession or something better termed a depression is how corporate credit responds. corporations are relatively underlevered coming into this bust, but there are two big negatives: credit is concentrated in vulnerable companies, and the intermediary system for corporate debt flotation -- the banking sector -- is itself the epicenter of the crisis.

if corporate credit suffers as severely as noland implies, i think episodic breakdown in the civil order -- so far from unthinkable -- is indeed probable.

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