Friday, March 14, 2008

Three monetary pessimists

As I argued in a recent post it is important for Australia to anticipate the likely success of US Federal Reserve moves to avoid a long and severe US recession. These three monetary economists are pessimistic and believe recession is a sure thing and that it will be long and severe. This suggests that commodity price pressures currently driving Australia’s terms of trade as well as local inflation will moderate the US economy weakens. To state the obvious it also means that Australia’s RBA must exert caution with respect to future interest rate hikes lest it induce a local recession here. Indeed the need to be flexible about possibilities for reversing interest rate movements might become apparent over the past year.

Thus although I have argued that the RBA are correct in placing heavy weight on limiting inflation and on maintain credibility for doing so (see here) I take the following pessimistic views seriously.

1. Nobel Prize winning economist Edmund S. Phelps takes a pessimistic view of control possibilities in a modern economy. He rejects the possibility of fine-tuning using monetary ‘financial engineering’ based on standard risk analysis as conceit. He foresees higher US interest rates and higher unemployment for wealth effect reasons – current monetary policies will only have short-term effectiveness. I agree completely – I am disgusted with the way contemporary macroeconomists trot out ‘natural rates of unemployment’ as guides as to whether the economy should be expanded or contracted. As Phelps notes the US natural rate will be higher now than in the past because of financially-induced long-term job destruction in the US residential investment sector. The natural rate idea is so volatile that it is not a useful guide to thinking about macroeconomic policy. Australia’s RBA said last year they don’t use the idea in their policy analyses and that seems sensible to me.

2. Gloomy Paul Krugman also believes that US monetary policy will fail and anticipates a long and deep US recession. It is not that the increasingly ‘desperate’ (Krugman’s word) Federal Reserve is not doing a lot – it is just that the scale of the US woes is so vast. The Fed is buying $400 billion worth of insecure bonds backed by mortgages – this is half of its available funds. To Krugman the current US difficulties look like becoming one of history’s great financial crises with the Fed bailing out the banks but the banks still being unwilling to lend. He seems these monetary woes as the major task of the next US administration. Ugly economics will create ugly politics.

3. David Roche completes the triumvirate of monetary pessimists. Hedge funds and other NDFI (non-deposit taking financial institutions) are now being hit by the credit-crunch. Roche says some strong things:

‘Creating a lot of liquidity does not resolve an issue of solvency, which is now the driver of credit contraction. All the Fed will achieve is a dollar that will be further debased and inflation that will be higher. It cannot stop the process of deleveraging and asset price decline’.

‘Credit contraction translates through the financial system into a reduction in available credit for the non-financial corporate sector, and thus into reduced investment and growth in the real economy. The size of that contraction can be estimated from the leverage ratios of the financial sector and their impact on real GDP growth.

We estimate that nonfinancial corporate debt ultimately will have to shrink by 11%-12%. This will generate a decline of five percentage points of real U.S. GDP growth and push the U.S. into recession. Europe's real GDP growth will contract by two percentage points.

Globally, total credit losses of $1.4 trillion will cause a contraction in world GDP of 2.5 percentage points, or half the current rate of global growth. So the global economy will become a gray, dull world of semi-recession and sticky inflation that will last a long time’.

Meanwhile there is value in trying to shut the gate even if the horse has bolted.


Anonymous said...

S&P came out and suggested total US problems loans will end up amounting to 300 bill which is a much smaller sum than previously thought.

I think these guys are over egging the problem, Harry. It's big porblem but we will begin to see light at the end of this year.

Don't underestimate the power of lower interest rates.

And how do these people see inflation in a recesssionary time. Prices should moderate during these times.

Lets not panic here.


conrad said...

I can't help but think number (2) looks like a description of a play-money scheme, where the government creates play money to buy other play-money that was created. Too bad it (and therefore the average American) gets all the risk with it, although I guess if you are going to spend a few trillion in Iraq, a few hundred billion on play-money doesn't matter. I also about whether it actually solves the initial problem of too much play-money. It will be interesting to see how low the dollar can go before they stop it and how they intend to fund their deficit into the future. Its already pretty clear many of the big buyers are sick of buying their bonds and buying companies instead is going to lead to a new round of nationalism.

derrida derider said...

"And how do these people see inflation in a recessionary time." - JC

Were you around in the 70s, JC? It's the same combination of massive unfavourable supply side shock (ie a diminution of real income that has to be shared out through some mechanism such as debauching the currency), negative real interest rates, huge fiscal and forex imbalances being unwound and devastated confidence. It's a perfect storm that we used to call stagflation.

I reckon the US is probably headed for a fairly long period of economic woes. I dunno, though, that things are as gloomy for the rest of the world - the days when the US sneezed and the rest of us got pneumonia have passed.

But we'll have to wait and see, because the state of the economic art isn't good enough for anyone to be confident as to how this will all play out. Just the same, I've rebalanced my portfolio for defence.

Anonymous said...

The 70's were not markeed with a credit implosion like we have.

There's huge deleveraging going on. Remind me when inflation has ever been a problem during such times.

Anonymous said...

That was me:

The US will clean up it act and be ready for the next 12 rounds in earlyish 09. The place has amazing flexibility. Don't throwthe kid out with the bath water just yet, DD


conrad said...

I'm gonna bet against you JC, as I can't possibly see how the US is cleaning up its act buying play money with play money (and what happens when the play money runs out?), albeit they'll get a few hundred billion dollars of disposable income back when they get out of Iraq. What's the best strategy for betting on a US recession and increased inflation -- obviously gold is one, but that also has some demand component -- any that don't?

Anonymous said...

Can someone elaborate how a credit cruch is not deflationary.

In the 70s when we had supply shocks and regulated markets we did get inflation but now in deregulated markets high oil prices merely decrease aggregate demand.

Corporate bonds are in a once in a lifetime opportunity.

look at the AAAs and then ask how any sane person could have a 9% chance of a default.

Swap spreads here are 14-150 which in essence are questioning the major banks viability.

These are mad times

Anonymous said...


You'd go broke betting against the US. There are plenty of dead bodies on the street over the decades of people making those bets. Cyclical recessions last about 18 months in the US.

Look S&P came out the other day and put a figure of around 280 billion as the haircut resulting from this mess. It's big but nowhere near the size of the last big banking problem of the early 90's when the US government had to bail out the S&L's. That loss was estimated at 300 billion at the time on a GDP of around 5.5 trillion. Two years later with the right policies the US was growing again. US GDP is currently 14 trillion.

Is the current problem a big one? Sure it is.

Is it bigger than the S&L crisis? No it isn't.

Has the Fed understood the nature of the problem.?


Damn straight they understand and they are acting, as they should.

Last week the Fed opened the window to the mortgage securities as collateral for 200 billion.

Later this month, they'll lower rates and the expectation is they go 1% with more to follow. This will further normalize the curve.

It's hard to see it but I think we are past the worst of it and we'll begin to see the light at the end of the tunnel.

The US stock market is amazing cheap at the moment with some decent opportunities.

I'm cautiously buying some great global banking brand names at the moment ... but very gently, especially after Bear Stearns failed on Friday.

Anonymous said...

that was me


conrad said...

Maybe I'm just pessimistic JC (although I realize thats what always happens in a recession :), but I think there are really two things -- one of which is inflation of energy and food prices, the other which is the banking system (the second of which I think will fix of course).

I'm basically betting that the Chinese are going to keep on driving commodity and energy prices up (quite possibly via letting the Yuan float more), and that will take years to get around. I don't think we've even seen the start of the problems caused by that.

I also think it will make lowering interest rates far less effective (as can already be seen), as it appears that each time this is done, the immediate effect on the consumer is some of it is gobbled back up via increases in their living costs. This means the effect from the banks falling apart will take far longer to fix.

Incidentally, you should be calling the current inflation inflation and not a one time movement in prices as some people like to see it unless you think commodity prices are going to fall back normal (impossible in my books -- unless the Chinese, Indians etc. stop using their cars, stop eating meat etc. again).

Also, if you want cheap banking shares, the Australian ones are very cheap (try the NAB) and presumably have far less exposure than the US ones, although I'll guess we'll find out.

Anonymous said...

the US interest rate curve is normalizing, conrad, while ours is pretty steeply negative. That usually is a good sign to stay well away from banks (ours).

The US banking sector.... ummm well Bear Stearn said good bye on friday and sentiment in that sector is very low. It's interesting though that bear basically fell because people took their funding and business from them. In other words it was a good old fashioned run on a bank. So it wasn't that they had run up huge losses.

Like every one else I'm worried but I think we'll look back and think some of those US banking names with great brand names will look very cheap over the next few years.


Anonymous said...

anon says:

Corporate bonds are in a once in a lifetime opportunity.

look at the AAAs and then ask how any sane person could have a 9% chance of a default.

How true. There are some absolutely terrific infrastructure funds sellings at amazingly cheap prices at the moment.

I have managed to lift my investment portfolio to a 1Oish % yield without too much effort or longer term risk. No, NOT banks.