The Unfolding Economic Scenario

The discussion in the previous post was precipitated by the extraordinary large drop in the target interest rate that the Federal Reserve uses in the conduct of monetary policy and the $150 billion stimulus plan proposed by the Bush Administration and the US Congress. Since then the Federal Reserve has proceeded to drop the target interest rate by another 50 basis points (an ‘unprecedented move’) and congress has forged ahead on the fiscal package. Financial markets, reacting to the Fed’s actions, have seemingly stabilized, although they are still volatile. The movement on the stimulus package has shown the world just how caring and responsive the Federal Government is when it comes to the plight of their political constituencies…even though concern exists that the effort will be ineffective, at best.

All this must be put within the context of the economic and financial developments that were presented in the last posting. The first development related to the financial innovation that has taken place in the United States over the previous 40 years. Although this innovation provided many benefits to individuals and institutions throughout the world, it also resulted in the ramping up of the riskiness of financial markets. Furthermore, the risk associated with innovation is connected with uncertainty as to how financial market volatility might come about as well as with the timing of the volatility. The second development related to the six year decline in the value of the United States dollar that resulted from the Federal Reserve maintaining a Federal Funds target that was at historically low levels for over two years. These two factors represent the back-drop for the events that are unfolding in the current period.

In the past, the economy of the United States has been sufficiently large that government policymakers could act as if it were independent of the other countries in the world. Economists discussed international macroeconomics in terms of ‘small countries’, countries whose balance of trade, etc., were affected by international markets. The United States was usually not considered to be a ‘small country.’ But, globalization has changed all that. The United States is now a ‘small country’ just as is every other country in the world (although still extremely influential). This makes a statement by Paul Volcker, former Chairman of the Federal Reserve System, more relevant today than ever before. Volcker has written that “a nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity.” (Paul Volcker and Toyoo Gyohten, Changing Fortunes, Times Books, New York, 1992, page 232.) Apparently, Alan Greenspan did not believe this to be the case.

The declining value of the US Dollar has seemingly resulted in a rising dollar price of commodities throughout the world, most importantly in the price of oil (but also in the price of gold). Again, looking at historical data on the price of oil the pattern seems to be inversely correlated with the decline in the value of the US Dollar. As a consequence, large amounts of dollars were accumulated in oil producing areas within the world, particularly in the Middle East, Venezuela, and Russia. The other major country that has accumulated US Dollars has been China. A major reason that China has accumulated US Dollars is that it has ‘not played fair’ in the foreign exchange markets. That is, China has not allowed its currency to float and this has resulted in its exports far exceeding its imports, especially when trading with the United States, and, as a consequence, has accumulated a large amount of dollars.

This is where the world financial markets come into the picture and they cannot be discussed without considering all of the financial innovations that have taken place in recent years. First of all, in the last seven years, the United States government has run large deficits. Countries, especially China, that have accumulated dollars financed a substantial amount of this new Federal debt. Arguments are made that one reason the US government has been able to finance such large deficits without causing interest rates to rise is that dollar holders have used their funds to buy US government securities and just hold them.

Second, eventually the hunt for yield went beyond just safety and looked for higher and higher returns. This is where the financial innovations of the United States became such a boon for foreign investors. Participants in world markets became almost insatiable in their demand for higher yielding US securities, particularly of the asset-backed variety…since they would be safer. United States financial institutions, battling for market share were very willing to create and supply such instruments. Whereas, previous innovations were not as easily duplicated and firms were able to preserve some market power for the creating institutions due to the existence of specific market niches and customer loyalty, many of the innovations of the late 1990s and early 2000s were easily copied and the creating institutions were not able to maintain any market power for their inventions. Returns to originating institutions tended to come from fees and trading profits so buying and holding these securities on their balance sheets was not important; these firms, therefore, emphasized volume rather than quality.

Third, physical assets located in the United States became more and more attractive to the holders of US Dollars. Although people within the United States became concerned with the thought of foreign ownership of US physical assets and politicians did block some deals, it was a natural progression for foreign institutions that held US Dollars to eventually migrate to ownership of physical assets. And, like the previous two developments, investment in these assets increased over time.

Now the riskiness of the new financial innovations comes into the picture. With all the money going into certain segments of the United States economy, especially housing, a mild inflation was sustained over time. This was not unusual for the housing sector since housing prices had risen on an annual basis for years. But, all of a sudden, the inflation in housing prices stopped and since many mortgages only made sense if the price of the underlying houses continued to climb, many of these loans, particularly in the subprime area where things like credit worthiness and equity in the home were no longer so important became less viable. Thus, the economic value of these mortgages declined and the value of the securities that were backed by these mortgages also declined. Unfortunately, for many reasons, people were unable to put a price on these securities.

There is not space here to give this aspect of the situation further coverage. The important thing is that this decline in the value of financial assets impacted financial institutions all over the world and large write offs had to be taken by many organizations (and will continue into the foreseeable future). The liquidity crises in such an environment never really materialized in 2007 when it was expected. Once this was avoided, the solvency crises had to be dealt with. The resolution of this problem has seemingly progressed more rapidly and more smoothly to this date than could have been imagined several years ago. Because these institutions were more closely tied to markets than they ever had been before, they had to recognize the declining value of these assets. Top executives were let go (and this will continue into the foreseeable future). It was only to be expected that new top executives would try and clean out as much of the bad assets as possible so they could move on. So, balance sheet adjustments were made (and this will continue into the foreseeable future).

But…this means that new capital needs to be raised for these institutions to remain solvent. Where is the money to come from? Aha! Those nations and organizations that have large dollar holdings have become the source. We have learned of a new institution called the Sovereign Wealth Fund, institutions that have billions of dollars to invest. And, as a consequence, we have seen the start of one of the biggest reallocations of wealth around the world that has ever taken place. And, United States monetary and fiscal policy had underwritten it!

Oh, yes, and what of the cuts in the target Federal Funds interest rate by the Federal Reserve and the fiscal stimulus package that is being put together?

There seems to have been a liquidity crisis in financial markets around January 21, 2008. At that time, a large French bank was faced with $75 billion of bad bets created by one of its traders, bets that ultimately cost the bank $7.2 billion in losses. The bank tried to unwind the ‘bad bets’ and, as is often the case in a liquidity crisis, word of the unwinding got out to the market. Liquidity crisis take place when the market knows that someone has to sell and has to sell a large position. No one wants to ‘bet’ on what the price will need to be to accomplish the unwinding. The market, in effect, retires to the sideline and waits to see what happens. The market, therefore, has no liquidity.

The Federal Reserve action on Tuesday morning, January 22 seems to have relieved this situation although it does not seem to have known about the trading activity of the particular French bank. But, if this is the case, then the Federal Reserve, inadvertently, did what it was supposed to do. It helped to avert a liquidity crisis. The additional reduction in the Fed Funds target on January 30, according to the statement that was released by the Fed, came “to promote moderate growth over time and to mitigate the risks to economic activity.” The immediate question, however, has to do with the solvency crises. Will this move help to resolve the solvency crises and then help spur on the economy. Markets and market participants seem to be uncertain this move will accomplish that goal.

And the stimulus package? There is continued skepticism about the effectiveness of the package and growing cynicism concerning the motivation for the package. The skepticism about the effectiveness relates to the argument that most people will not spend the funds they receive from the package but will either save them or use them to pay down existing debts. Economists contend that people spend based on their longer-term expected or permanent income and not on temporary windfalls. The evidence of the past two efforts to provide short-term fiscal stimulus to the economy indicate very little impact on spending from such temporary injections of funds.

In terms of the cynicism concerning the motivation of the package, more and more analysts are contending that the politicians had to do something in order to appeal to the voters. They could not afford to look like they were sitting on their hands and doing nothing. Otherwise, anyone that might oppose them would be able to point to this situation to show that the politician did not care about the state of the economy and was reluctant to help people. Maybe the best one can hope for is that the stimulus package will not do too much damage to the economy. If it does any good…that would be a bonus.

Where does this leave us? In my opinion, there is still too much uncertainty relating to the health of the economy to make a confident prediction about a recession or the depth of such a recession, if one comes. Regardless the exact path, the economy has to transition through the dislocation in the housing market and in other asset markets connected with the financial innovations of the last decade or so.

We still have to be concerned with the US Dollar. The Federal Reserve could raise interest rates. This is the typical action of a central bank that faces a weak national currency. Right now, however, the Fed does not have this option. And, with European central banks unwilling to make any move that will weaken the Euro or the Pound, any drop in US interest rates will just further depress the dollar. There seems to be little or nothing the Fed can do now to resolve this problem at this time.

A weak dollar continues to make US physical assets cheap and continues to encourage more foreign investment in the United States. The Bush Administration has created an environment that is resulting in the greatest sale of ownership of US physical assets to foreign interests in the history of the United States! Globalization has come home!