Monday, January 28, 2008

What a week this was!

Stock markets going crazy all over the world! As a consequence, the Federal Reserve reduced its target interest rate by ¾%, or 75 basis points, the largest reduction in this target rate in many a year. Growing concerns about the United States slipping into a recession (Whoops! The ‘R’ word…). And this was met by the US Government producing a $150 Billion stimulus package that was put together by Republicans and Democrats working together!!!!!!!! Wow! What can top this?

And, what is the response to these actions? Well, the stock markets have seemed to stabilize…for the time being. (Note: the cuts by the Fed were not followed by other central banks throughout the world except in Canada.) The ‘on-the-street’ noise was that Fed Chairman Bernanke panicked, calling a special teleconference meeting on Martin Luther King Day so as to be able to make an announcement before the market opened on Tuesday. This move came the week before a regularly scheduled meeting of the Fed, a meeting in which a target interest rate cut had already been signaled by Bernanke. Now, the futures market is projecting further cuts over the next 6 months bringing the target rate to lows that seemed impossible to consider even two weeks ago.

What about the stimulus package? Many have declared it a victory…a victory for the politicians who want to show voters their concern for ‘the people.’ The argument goes that both Republicans and Democrats, with elections in the works later this year, could not go back to the nation without being able to show people that they had given ‘their best shot’ toward reducing the impact of an economic slowdown.

What can we expect from all this activity? That is not an easy question to answer. An effort will be made to provide some kind of an answer to this in today’s posting and the posting for next week. The reason for this is that I want to spend the remaining space in today’s posting to discuss the possible causes of the current situation so that we have a foundation to examine the potential future consequences of the actions taken last week. Economic actions tend to take quite a long time to work themselves out in the broader economy. And, whereas these economic actions may have many beneficial short run effects, the longer run results may create situations that are not so good and that may be quite difficult to unwind. Often, in the economic sphere, we find ourselves fighting battles that have causes which took place many years ago and are not easily recognizable. Humans, tending to be current orientated, tend to look at recent events for a cause and design responses that are not totally appropriate and may have unpleasant consequences in the future.

Let’s limit this week’s historical review to two factors. The first has to do with the financial innovation that has been a part of the financial scene for over forty years now. This has been a tremendous benefit, not only to the United States, but arguably, to the whole world. The financial innovation that has taken place during this time has resulted in markets becoming much more efficient, as well as broader and deeper. The consequence? More funds have been allocated to segments of the economy than ever before allowing more and more people to obtain financing than could ever have been dreamed of. Of course we think of the subprime market now, but when mortgage backed securities were created in the late 1960s and early 1970s, the concern was with the ability of the financial system to provide mortgages to ‘middle income’ America so that these people could realize the American dream of owning their own homes.

But, what about businesses? In the 1960s it was very, very difficult for a potential entrepreneur to get funds to start up a business. Venture capital was in its infancy and the only real source of funds, besides one’s family and friends, was the commercial bank. Commercial banks, however, required evidence that a loan could be repaid and that a person had some kind of tangible net worth, like equity in a home. An entrepreneur did not have a network of specialized venture capitalists to go to…or private equity funds…or hedge funds. Starting up a company back then was a ‘hard knock life’!

As David Brooks mentions in his New York Times piece of January 25, 2008, there is a tension in a capitalistic society between certainty and innovation. If we believe that innovation is good for the economy and the society, then we must accept the fact that there will be greater uncertainty with respect to future events. ( Over the past forty or so years, financial innovation has become a world-wide phenomenon and many have benefited from this innovation and not just the financial types that created the innovation. This innovation has created uncertainties. But, specific uncertainties cannot be forecast, they just happen. What this means relative to the situation we are now facing will be discussed next week.
The second factor is the behavior of the Federal Reserve during the Bush Administration. If one looks at the chart of the Federal Funds Target Rate of Interest for the period beginning in 2002 to the present, it can be observed that the target rate was kept extremely low for over two years beginning in 2002. ( The argument given for the behavior of the Fed was the attack of 9/11 and the additional fear that the downside risk for the economy was quite high. In effect, the actions of the Fed underwrote the economic policies of the Bush Administration and supported its re-election in 2004. Arthur Burns was faulted for helping to underwrite the re-election of Richard Nixon in 1972 because of the subsequent impacts his policies had on the economy. One could argue that Alan Greenspan outdid Burns in his support of Bush.

There were immediate consequences of this behavior: the value of the dollar declined. It is remarkable to place the above referenced chart next to one showing the Dollar’s Trade Weighted Exchange Index. ( Here we see that the measure of the Exchange Index peaked near the same time that the Federal Funds target was placed below 2%. The Exchange Index continued to fall throughout the time the Federal Funds target was kept at very low levels and only seemed to stabilize (not rebound) when the target was raised throughout 2005 and 2006. It can be noted that the Exchange Index began to decline again as the concern about the health of the United States financial system grew in 2007.

Why is it important to recall these two historical facts? The reason we need to recall these is that we are living with their consequences. And, since these events happened many years before the current period we need to refresh our minds as to their presence so that we can better understand the events of today. But, it is not the case that one caused the other. It is just that their co-existence has resulted in an environment that is more combustible in the sense that these two factors have reinforced the uncertainties within the financial markets and have exacerbated the difficulties that policy-makers have to deal with in terms of resolving the perceived problems that have arisen.

Markets hate uncertainty. Furthermore, markets don’t like policymakers in which they have little confidence. Up-to-this-date, the policymakers handling the situation have not provided the markets with a lot of confidence. For example, in an article in the Wall Street Journal on Friday January 25, 2008, Bernanke and the Fed come under much criticism. It is not the policies, per se, that are the subject of criticism, but the way in which Bernanke and the Fed have presented the policies over time. James Bianco, president of Bianco Research LLC is quoted as saying: “…part of the Fed’s job is political theater as opposed to the actual levers they pull, And he (Bernanke) has failed so miserably on the political-theater aspects that it’s overwhelming the things that he might be doing correctly.” ( The new stimulus package, also, has not garnered much favorable response, from either the right or the left. (

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