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Monday, April 06, 2009


altman on the depression

calculated risk and others have noted roger altman's description of events and the way forward in the financial times.

The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out, as are nations such as Japan and Mexico that depend on US demand. The implications for US policy include a likely second round of stimulus, much more federal capital for the banking system and stunning budget deficits that will slow key initiatives for President Barack Obama, such as healthcare and energy reform.

What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.

... [W]e saw a housing and credit market collapse that caused enormous losses among households and banks. The result was a steep drop in discretionary consumer spending and a halt to lending. To see why recovery will be slow, we can look at the balance sheet damage. For households, net worth peaked in mid-2007 at $64,400bn (€47,750, £43,449bn) but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big – especially when household debt reached 130 per cent of income in 2008.

... [H]ousehold balance sheets will not be rebuilt soon. Home values will keep falling through mid-2010 and there is no precedent for equity markets, still down 45 per cent from their peak, to make those losses up in just two years. It is illogical, therefore, to expect a full snap-back in the consumer sector in 2010 or 2011. This alone mandates a drawn-out, weak recovery. ...

This weak outlook is likely to force a second injection of spending rises and tax cuts in 2010 to prod demand. Despite public opposition, substantially more federal capital will be required for banks. The deficit outlook will worsen, perhaps to $1,000bn annually over 10 years. That will force a slowing of Mr Obama’s investment plans. That is a shame, because those investments are needed, but this balance sheet recession will be too deep.

if someone of altman's stature -- former deputy treasury secretary and founder of investment banking boutique evercore -- is on this page, one can have hope that many others in altman's wired circle are.

he also mentions possible limitations to fiscal stimulus as a result of combined borrowing for both fiscal stimulus and bank recapitalization. however essential as some amount of government aid in the direction of recapitalization is, that does indeed have potential to be seriously problematic. the obama administration must be careful to put demand management first. if it does not, if too much of the cash flow being poured into banks by the private sector is directed at capital transfer and not at maintaining demand, the potential results would seem to me at least fourfold:

  1. a need to float internationally treasury debt more or less equal to that pumped into capital transfers, in spite of much lower trade volumes and a massive global competition among sovereigns to do so, likely at the expense of demand management efforts overseas which we may well feel here at home;
  2. monetization of that same quantity on the part of the federal reserve, with potentially destabilizing consequences for the dollar beyond some murky tipping point of confidence;
  3. a rise in interest rates, forcing increasing amounts of capital out of alternative capital markets, such as that for stocks;
  4. a refusal to authorize sufficiently large deficits to do both, leading to insufficient demand replacement, leading to a deepening of the depression characterized by contractions in incomes, cash flows and yet more asset prices.

in the worst case we could see more than one of these effects, either in succession or simultaneously. none would be particularly welcome.

UPDATE: the recognition of the role of the balance sheet, particularly of debt, is happily increasing. witness via mark thoma quoting from the pages of the wall street journal, juxtaposed with the blogging of paul krugman.

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"But, within two years, concerns over budget deficits and inflation may revive, compelling the Federal Reserve to raise interest rates and Congress to adopt deficit reduction steps."

Jim Hamilton@econbrowser has highlighted studies by John Taylor , as well as offered his own perspective , that this downturn would not have been so severe but for the oil shock of 2008. He blames the Federal Reserve aggravating this commodity boom. Bernanke on the other hand, probably saw ahead, that the slowdown would bring inflation under control eventually. It looks like a case of damned if you do and damned if you don't.
In the real world, what if similarly premature acts to bring down the deficits such as occurred in 1937, Japan in 1997 and 2001 are also similar -- that the price of inaction would create a currency crisis due to untethered inflationary expectations?

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i can't make a good case for or against that, rb -- looking at the yen in 1997 and 2001, or JGB yields, there's not much indication of something like a run. but that's no substitute for having a window on the zeitgeist. the fear of difficulty can be every bit as powerful as the actuality, and i'm sure such reasons were part of the argument.

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The question of the extent to which bailouts and bank recapitalization will pressure treasury funding and interest rates is important... I suspect that the concern is overblown in the same way that concern about funding for fiscal deficit spending has been. As you know, for fiscal stimulus Richard Koo points out that the increase in savings will fund the increase in treasury issuance.

With recapitalizations, again, no money is created or destroyed. To walk through the mechanics:

1. The treasury issues bonds to raise cash for use in recapitalizations (here is the increase in marginal treasury supply, keep reading to see where the offsetting marginal demand comes from).
2. The treasury injects the cash as capital into an organization, thereby adding cash to the asset side of the balance sheet and equity to the liability side.
3. Whether or not writedowns are occurring at the organization is independent of the recapitalization and treasury funding dynamics so I think we can ignore the writedowns here
4. The organization now has two choices:
4a. Put the new cash to "work" (swap cash for assets on asset side of balance sheet) -- in a world with little new loan demand, odds are this means buying treasuries, so this is where the marginal treasury demand increase occurs.
4b. Shrink the balance sheet by paying off debt. The effect is that on the balance sheets of the bondholders, loan assets convert to cash as this debt is repaid. These organizations then face the same choice between re-invest or reduce balance sheet (goto step #4 again!)
- Ultimately the recursion in step #4b stops at organizations or individuals with no need to shrink their balance sheets (i.e., only equity on the liability side), so the marginal increase in treasury demand will show up eventually down the chain.

Anything wrong with this logic?

But this doesn't mean there is nothing to worry about, e.g.:

A. A contracting money supply (to the extent that loans were via fractional reserve lending as opposed to bonds) seems problematic for all asset prices. Though perhaps QE can offset this effect?
B. Too much debt was created on aggregate (Minsky's theories regarding ponzi financing) so it may not all be able to be repaid whether on or off government balance sheets. I guess this gets into the risk of a government debt so large it would have to be defaulted on. I wonder how large that would have to be if Britain really paid down government debt from the level of 250% of GDP! Maybe even Japan (180% of GDP) has hope :)

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An interesting, though probably simple, observation that this is all about preservation, and not about destruction .

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it is, rb, but i would hold at arms length a lot of what baruch says.

he holds a narrative of economic history where IMF prescriptions "worked great". that's highly questionable, and much depends on what you mean by "worked". there's no doubt one can achieve spectacular growth rates in the aftermath of an unimpeded collapse in monetary aggregates. but from what level? there's a reason the IMF is detested throughout the third world. that it worked great from the comfortable distance of new york is perhaps a more truthful submission.

moreover, to say that japan is "in the crapper" and attribute that to the fiscal demand management of 1990-2005 is both to hypersimplify their issues and presume correlation means causation from a great distance.

this is an interesting adjunct, rb, of posen's argument that you mentioned. posen et al thinks things got better thanks to addressing toxic assets following 2002's "takenaka shock" (a combined program of spending reductions and forced writedowns) with an assist to QE. baruch thinks things are still bad thanks to fiscal stimulus. this strange pair seems (in my anecdotal view) to broadly define the widely-held american interpretive biases re: japan -- and while superficially dissonant, both carry a moral undertone of painful reckoning.

posen is wrong on the basis of data, imo. domestic lending out of japan's banks simply did not pick up post-takenaka, even out to 2007 (which is all the data i've seen). the economic recovery that took place there was to some extent export-driven, but as importantly domestic businesses -- having driven aggregate corporate debt down to levels not seen since the pre-export-model 1950s -- began to redirect large cash flows from debt paydowns to economic activities in 2002 and 2003.

now of course they are suffering a different kind of shock, which baruch seems to conflate with the 1990-2005 malaise -- an external shock that strikes at the heart of their economic model as a provider of excess capacity. it is not (imo) properly interpreted as a result of demand management, QE or much else except the nature of japan's economic model and the pressure globalization is putting on it.

but most interesting of all, in my view, is the need -- the moral need -- of people of even widely differing views for a painful reckoning. if i might be so bold, this emotional desire to see pain inflicted in recourse to excess is not rational but nevertheless evident here as elsewhere. it reminds me much of jack lule's book -- the need and will to impose archetypes best described as mythologies onto our situation in order to come to a simian understanding of a just world is extremely powerful. thinking back on the media coverage and the diaspora of analytical responses -- which have not been exclusive, indeed far from it -- one can easily pick out examples of some of lule's master myths: the victim, the trickster, the scapegoat -- and, particularly in this event, the flood.

lule's book is priceless and i shoudl reread it now, but even just this article from the wake of the aceh tsunami may be instructive. the narrative has moved through the devastation phase, the humanity humbed phase, and we are clearly now in the rebuilding phase with a liberal dose of "striking those who have strayed". (this of course regardless of where we are in reality -- this is entirely about perceptions.)

i would suggest we be very careful of who we strike, because it could be the satisfaction of our moral need to strike that could kick off a much deeper destruction.

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You are correct that the current external shock-induced collapse does not imply a failure of the fiscal expansion from 1990-2005. Lule's book sounds interesting, I should check out our public library.

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