Wednesday, June 03, 2009
harrison posits two likely competing outcomes.
- No policy traction. This is a sluggish muddle-through Japanese scenario where the Richard Koo thesis of the balance sheet recession comes into play. You would see an output gap and below-trend growth for an extended period. Most pundits would say it is the lack of lending that is creating the problem. However, what if it is the lack of borrowing which is at fault? Then, we are going to see no traction from monetary policy.
- Start-Stop economy. I believe Bernanke would prefer this outcome. This is one in which the Federal Reserve allows the economy to recover by keeping interest rates low. The result is a rise in inflation. We could see inflation rising to 3 percent inflation and then to 5 to 7 and 10 percent. An example would be animal spirits coming back in 2010. And leading to 3 percent inflation followed by 7 percent including $100 oil and then interest rate hikes and another recession at which point the deleveraging begins again in earnest. Followed by more easing and on it goes. But, of course, the problem with outcome two is it is unstable and that it invites an aggressive policy response which risks situation one as an ultimate outcome.
Neither of these scenarios is one in which asset markets are likely to benefit, one reason I see the latest uptick in share prices as nothing more than a bear market rally.
i obviously think highly of koo's analysis, but i'm very wary of the major difference between the export-oriented japan which koo analyzed and the import-oriented united states of today -- which is the current account balance. the china of 2007 was really the analog of 1990 japan or 1929 america, and the politburo will hopefully follow the prescription of policy heavyweights like koo through the bust.
but the united states faces the collapse of its internationally-funded wholesale financing as its current account deficit collapses, and this is a major problem for its banking system. excess deposits -- abundant in then-japan and now-china -- will in the united states likely be directed at reducing the american systemic dependency on wholesale funding, which is to say deleveraging.
even as loan demand collapses, keeping monetary policy more or less completely ineffective for the duration of the balance sheet recession, the united states will face a desperate need for marginal capital importation -- and that will keep marginal funding and therefore interest rates expensive. to the extent that the treasury-fed complex (for that is what seems to be evolving, much to the chagrin of those who value central bank independence) replaces the private markets (particularly the felled giants of securitization) as the importer of that capital, it is the yields of treasury instruments which stand to rise.
the result might actually look like a third, unmentioned outcome, combining koo's sustained output gap with persistently high interest rates working to choke any recovery and accelerate deleveraging -- supplemented by a disquieting but ever-present background threat of a sudden stop in foreign financing which would spike interest rates and catapult the united states into a sharper, deeper depression characterized by rapid forced liquidation.
in any case, harrison usefully tracks what he labels the consumption-to-income gap (CIG), shown here back to 1960.
My view on how to view this statistic is this: if the CIG continues in negative territory, look to the first outcome ... as the likely scenario to expect. However, if the CIG turns positive, this would mean the reflation trade has gained traction and scenario #2 would be the likely outcome.
In terms of the rally in shares now ongoing, scenario #2 is bullish for the period after 2009 because it means the economy will be supported by ‘excess’ consumption. On the other hand, scenario #1 is not bullish because it will mean a weak economy and a potential double-dip.
Watch the Consumption-to-Income Gap. I think it will be an important statistic to follow in terms of gauging where consumer spending is headed and what impact that will have on retail sales, company profits and stock prices.
"the united states will face a desperate need for marginal capital importation -- and that will keep marginal funding and therefore interest rates expensive."
I'm still having trouble with this concept, since I see interest rates as set based on comparative opportunities WITHIN a given currency rather than ACROSS currencies (even if exchange rates are impacted by the ACROSS currency rate differentials).
Can you point to evidence in the data (e.g., Fed or banking system publications) supporting this thesis, i.e., that the need for dollar-based wholesale funding from foreigners is driving higher rates?
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1. In the case of "sudden stop" of funding or capital flight (per Hempton), it now makes sense to me that this would contract bank funding on aggregate (as well as having obvious currency impacts), IF the appropriate analogy is to a bank run in which depositors withdraw money and stuff physical cash in a mattress. i.e., an action based on fear that leads to return of capital but zero return on capital. Is this accurate? If so are any programs or guarantees at the international funding level analagous to FDIC insurance, and is it possible Korea was lacking those for its crisis?
2. Absent capital flight, it now seems logical to me that wholesale funding interest rates be different than depositor rates, but I'm still at a loss as to why the difference would be big enough to keep longer term rates meaningfully higher. Rates such as LIBOR have almost normalized recently and it seems like we are talking 50 bps or less, at least on these measures. Not that different from depositor rates. So why would this doom the US to meaningfully higher rates than Japan (absent capital flight)?
3. In your comment at baseline scenario, you tie the wholesale funding topic into an explanation of why treasury yields have been shooting up. But absent the "stuffing the mattress" analogy, I'm still at a loss as to where else (dollar denominated choices) the capital would be going? If it's all just shifts to shorter duration assets (such as Brad Setser describes of China's CB) then isn't that dynamic independent of any wholesale funding vs domestic depositor issue (i.e., more about inflation expectations) meaning that the US isn't that different from Japan after all? (Personally I think the inflation expectations will come under assault when falling rents start dragging down CPI more dramatically, if not sooner).
Thanks as always for such thought provoking writing!
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So why would this doom the US to meaningfully higher rates than Japan (absent capital flight)?
japan of course had excess domestic deposits and so ZIRP became reality. because the US has to borrow foreign despoits across an exchange rate, there will likely have to be a risk premium to compensate the lenders even if those deposits are borrowed out of ZIRP blocs. it might not be huge, but it should certainly be more than ZIRP and may vary with exchange rate volatility.
i think of it rather as a global competition for forex eminating from the remaining CA surplus countries. some countries are/will be losers -- iceland, ukraine, now maybe the baltics and other EEC/CEC -- and not everyone can be fed as global trade falls and imbalances correct. to win you need to offer some attractive combination of yield and safety. with the US being a monster importer of forex -- relative not only to its own economy but to the global pool of available forex -- i don't think it will be a frictionless win for the US on grounds of safety even if i don't think sudden stop is inevitable or even likely.
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Here's another data point on why the treasury yield changes seem independent to me of foreign funding issues... isn't Germany still a CA surplus country? via Mish: ...rates were rising all over the world. Indeed, yields on many equivalent European bonds, including the Bunds, rose by even greater amounts.
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