It is official now…the United States has been in recession since December 2007! Right now the current recession is the third longest recession since World War II and most economists believe that this recession will at least tie the other two recessions in terms of duration…a period of 16 months.
Among the major factors behind such a belief is that housing prices are still declining, housing sales are still falling, layoffs have just started to takeoff and financial institutions are still reluctant to lend…even if people and companies are willing to borrow. Some feel that the real recession is just starting to hit.
Growth-wise, real GDP rose, year-over-year, at a 0.7% rate in the third quarter of 2008, down from 2.8% in the third quarter of 2007 and 2.3% in the fourth quarter of that year. Real GDP declined in the third quarter of 2008 from the second quarter of 2008 and is expected to decline once again going from the third quarter to the fourth quarter.
The extent of this recession has even got some people talking about deflation!
Now that is something! It is something because the year-over-year rate of change in the Implicit Price Deflator of GPD, although it drops when there is a recession, has only become negative once since World War II and that was in the 1948-49 recession. (See chart from the Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=GNPDEF&s[1][transformation]=pc1.) Over the past seven quarters the Implicit GDP Price Deflator has averaged a 2.5% year-over-year rate of increase and increased by 2.6% in the third quarter of 2008 over the third quarter of 2007.
It is important to talk about what is happening to prices at the same time one is talking about what is happening to economic activity because that gives us a clue as to what factors are dominating economic activity. If both prices and output move in the same direction then one can say that demand factors are dominating the market. If prices and output move in opposite directions then one can say that supply factors are dominating the market. To understand what is happening in the economy, one must get some feel for which side of a market is dominating.
As the rate of growth of the economy has dropped from the rate of expansion that took place in the four quarters ending in the third quarter of 2007 (2.8%) to the four quarters ending in the third quarter of 2008 (0.7%), the rate of inflation for the same periods remained roughly constant or has declined modestly. To get such a result the drop in the demand for goods and services would have had to been roughly matched by the decline in the supply of goods and services over this time period. That is, neither side of the market strongly dominated the behavior of the economy over the past year or so.
As I have written in several posts over the past year, supply factors seem to be just as important as, or even more important than, demand factors in the current slowdown. That is, an adjustment is taking place on the supply side of the economy that must be reckoned with if we are to fully understand what is going on in the economy and respond to the situation as effectively as possible.
A possible reason for the shift in supply is that transitions are taking place in the economy or need to take place in the economy and this is impacting cost structures and organizational patterns in a way that is altering how people do business. For example, the increase in the cost of oil during the 2007-2008 period may have caused the transportation and energy industries to begin adjusting to a new world of alternative products and services that rely less on fossil-based resources. The subsequent reduction in the cost of a barrel of oil may have little impact on decisions because of the ‘price shock’ that people absorbed through the summer of 2008. The problems in the automotive industry are just one consequence of this. And, we are seeing a lot more adjustments coming in different segments of the transportation area that are not getting such a high profile. Also, new efforts to build ‘green’ industries may result from this.
Another transition is occurring in the financial industry where thousands of people are being laid off due to the downsizing that has resulted from the collapse of the financial markets. Financial institutions, I believe, are going to go through a substantial restructuring that will be based on information technology. In the past thirty years, the financial industry has shown how it can use the computer to design financial products. Now, along with the call to restructure the regulation of financial institutions, the financial industry is going to have to use the emerging information technology to control risk and enhance the openness and transparency of the industry. In moving in this direction the financial industry will become a real leader in the creation of information markets on which the rest of the economy will model itself.
Information technology continues to transform itself and in so doing will continue to create opportunities for other industries to transform themselves. The spread of information is going to accelerate with search being an integral part of this expansion along with greater and greater connectivity between users throughout the world. Computer networks will more and more become decentralized rather than centralized.
Another area where substantial transitions are taking place is in the area of State and Local governments. The model that has been used in this arena developed after World War II and is in need of a vast overhaul. In all likelihood, the current financial difficulties are going to result in these governments modernizing their function and structure while at the same time they help rebuild the infrastructure.
These are just a few of the major transitions that are taking place in the economy right now and that predominantly affect the supply side of the economy rather than the demand side. In all the efforts to “get the economy going again” we must not restrict or prevent these changes. That is, the government programs that are designed to stimulate the economy must not “lock us into” the old way of doing things. A bailout of the auto industry that keeps things “as they are” will not be helpful in the longer run.
It could be that the economy of the United States, and the world, is now going through a major restructuring, a restructuring that seems to occur every 60-80 years or so. In a sense, we are going from one age into another. One could say that the United States went through another major restructuring in the 1930s when the country was transitioning from an economy based predominantly upon agriculture to one that was based predominantly upon manufacturing. Maybe this is the time of transition from manufacturing to (you insert your term for it). Maybe the world of the ‘manufacturer’, and all that supports it, has significantly passed its peak and government props can no longer sustain it.
Two things can be drawn from this. First, government programs that just rely on stimulating demand will not prove to be very effective. The transitions must take place. They will take place relatively rapidly or they will take place at a much slower pace if the government supports the status quo. We…the government…must be careful here.
Let me state this again…the adjustments are going to take place…whether or not the government slows them down!
Second, these areas of transition are going to create major new opportunities for investment to those that are lucky enough…or wise enough…to choose the right companies. Referring to the 1930s once again, one can reference many investments that provided exceptional returns to those that sought them out and committed to them during the period in which the economy was adjusting to the brave new world that was coming. It is my belief that there will be numerous such opportunities available to us in the near future.
Showing posts with label financial bailout. Show all posts
Showing posts with label financial bailout. Show all posts
Tuesday, December 2, 2008
Friday, September 26, 2008
The Two Major Issues in this Crisis
There are two major issues that have to be confronted in this crisis. First, there is the pricing of assets. Second, there is the issue of capital. In my mind, the two need to be kept separate.
The first concern is that there are many securities that, at present, don’t have a market and hence their prices cannot be determined. This is primarily a short run issue. Typically in a situation like this the Federal Reserve provides sufficient support for the financial markets so that the markets stabilize and trading can once again take place. We are beyond that situation now and so we have to look further into what kind of problem might exist.
The situation we are in now is related to what economists call “the accelerator model”, a way of looking at things that Ben Bernanke is particularly fond of. On the up-side, the accelerator model helps explain what Charlie Kindleberger, an economist at MIT, popularized as the “mania” portion of a bubble. (See Kindleberger’s book, along with Robert Aliber, titled “Manias, Panics, and Crashes…a classic.) The problem with manias…and panics…is that they are cumulative. That is, they build on themselves.
The “accelerator model” in modern terms has a feedback mechanism in it that can create cumulative movements in asset prices. The particular channel this feedback mechanism works through is individual wealth. As the economy expands, asset prices rise. As asset prices rise, the wealth of individuals increase and they spend more out of this increased wealth. This additional spending raises asset prices further, credit grows to support this increase, and this leads to another round in which wealth grows further…an so on and so on.
Adherence to this model helps to explain Bernanke’s fear of inflation before last August.
But, the “accelerator model” works on the downside as well. The downside result has often been referred to as “deleveraging” or as a period of “debt deflation.” Here, as the economy slows or asset prices dip, the wealth of individuals declines. People reduce their spending and asset prices fall further. As asset prices decline, credit is tightened and this exacerbates the drop. This, obviously, is cumulative in behavior.
Just as Bernanke was concerned about the possibility of inflation in the spring and summer of 2007 he became extremely concerned about the possibility of debt deflation a week to ten days ago.
Did Chairman Bernanke panic? Did he over react? Only time will tell.
The issue before Congress now is whether or not they should enact a bailout plan that will help to stabilize the asset prices of a vast quantity of securities. Setting aside $700 billion in funds to help stabilize the market is the primary goal of the proposal.
ASIDE: whether or not the total is $700 billion or $1 trillion or $2 trillion is irrelevant. Supposedly when ask, a Treasury official said that there was no good reason for the choice of $700 billion, it was just that the number had to be quite large. This, of course, did not build confidence for the Paulson plan. However, in my judgment the answer is the correct one. No one knows how big the number needs to be. The crucial thing in a debt deflation is that those that are attempting to get out ahead of the situation need to have a lot of “chips” to play with. Whatever the number was it had to be a big one!
Return to message: is a proposal like this needed? Will such a proposal work? As I said in my Monday post…this is decision making under uncertainty…and this is beyond graduate school!
Another question that is being raised by House Republicans is whether or not this bill is philosophically (or ideologically) correct. The model these members of Congress work with initially cause them to reject such government interference with the market place. They have their arguments and we need to hear them before a final bill is passed. Any bill that is passed must have the general support of all members of Congress.
The second issue has to do with capital adequacy. It is argued that many financial organizations do not have sufficient capital to absorb the losses that exist on their balance sheets and will find it extremely difficult to continue business as usual if they are under-capitalized.
This issue is completely different from the first issue discussed above.
There are two choices here…either the market is allowed to work in the re-capitalization of these institutions or we allow the government to “invest” in these firms and become “owners”. The latter solution would mean that these institutions would be nationalized and we would, explicitly, socialize the financial system.
I guess we could call a combination of the two a possibility, but this would really be just bastard socialization…once you start this you have a socialized system regardless of how much of the system is in private hands.
To me there is no choice. I argue that the market should be allowed to determine who stays and who goes. What this will mean, however, is that more and more capital for American institutions will come from off shore. That is, the “wonderful” support for United States debt that has been accelerating in recent years, along with the decline in the value of the dollar, will lead to more and more foreign ownership of America’s assets.
Given this scenario, the major reason that might be given for a socialization of American finance is to keep it under American ownership, even if that ownership is coming from the government.
These two issues are the most important ones being faced in the current crisis. All the other things, to me, are secondary and should not muddy the waters of the debate going on.
ANOTHER ASIDE: I cannot agree with those that believe that this crisis was caused or exacerbated by “mark-to-market” accounting. I firmly believe in “mark-to-market” accounting because it increases the transparency of an institution’s decisions. Yes, it the market is moving around a lot there will be a lot of changes recorded on the balance sheet of a company, but, it was the management’s decision to have acquire such assets and the affect of these decisions should be obvious to shareholders and others. Riskier assets will require more marking to market. That is the choice of management. That choice should not be hidden.
The first concern is that there are many securities that, at present, don’t have a market and hence their prices cannot be determined. This is primarily a short run issue. Typically in a situation like this the Federal Reserve provides sufficient support for the financial markets so that the markets stabilize and trading can once again take place. We are beyond that situation now and so we have to look further into what kind of problem might exist.
The situation we are in now is related to what economists call “the accelerator model”, a way of looking at things that Ben Bernanke is particularly fond of. On the up-side, the accelerator model helps explain what Charlie Kindleberger, an economist at MIT, popularized as the “mania” portion of a bubble. (See Kindleberger’s book, along with Robert Aliber, titled “Manias, Panics, and Crashes…a classic.) The problem with manias…and panics…is that they are cumulative. That is, they build on themselves.
The “accelerator model” in modern terms has a feedback mechanism in it that can create cumulative movements in asset prices. The particular channel this feedback mechanism works through is individual wealth. As the economy expands, asset prices rise. As asset prices rise, the wealth of individuals increase and they spend more out of this increased wealth. This additional spending raises asset prices further, credit grows to support this increase, and this leads to another round in which wealth grows further…an so on and so on.
Adherence to this model helps to explain Bernanke’s fear of inflation before last August.
But, the “accelerator model” works on the downside as well. The downside result has often been referred to as “deleveraging” or as a period of “debt deflation.” Here, as the economy slows or asset prices dip, the wealth of individuals declines. People reduce their spending and asset prices fall further. As asset prices decline, credit is tightened and this exacerbates the drop. This, obviously, is cumulative in behavior.
Just as Bernanke was concerned about the possibility of inflation in the spring and summer of 2007 he became extremely concerned about the possibility of debt deflation a week to ten days ago.
Did Chairman Bernanke panic? Did he over react? Only time will tell.
The issue before Congress now is whether or not they should enact a bailout plan that will help to stabilize the asset prices of a vast quantity of securities. Setting aside $700 billion in funds to help stabilize the market is the primary goal of the proposal.
ASIDE: whether or not the total is $700 billion or $1 trillion or $2 trillion is irrelevant. Supposedly when ask, a Treasury official said that there was no good reason for the choice of $700 billion, it was just that the number had to be quite large. This, of course, did not build confidence for the Paulson plan. However, in my judgment the answer is the correct one. No one knows how big the number needs to be. The crucial thing in a debt deflation is that those that are attempting to get out ahead of the situation need to have a lot of “chips” to play with. Whatever the number was it had to be a big one!
Return to message: is a proposal like this needed? Will such a proposal work? As I said in my Monday post…this is decision making under uncertainty…and this is beyond graduate school!
Another question that is being raised by House Republicans is whether or not this bill is philosophically (or ideologically) correct. The model these members of Congress work with initially cause them to reject such government interference with the market place. They have their arguments and we need to hear them before a final bill is passed. Any bill that is passed must have the general support of all members of Congress.
The second issue has to do with capital adequacy. It is argued that many financial organizations do not have sufficient capital to absorb the losses that exist on their balance sheets and will find it extremely difficult to continue business as usual if they are under-capitalized.
This issue is completely different from the first issue discussed above.
There are two choices here…either the market is allowed to work in the re-capitalization of these institutions or we allow the government to “invest” in these firms and become “owners”. The latter solution would mean that these institutions would be nationalized and we would, explicitly, socialize the financial system.
I guess we could call a combination of the two a possibility, but this would really be just bastard socialization…once you start this you have a socialized system regardless of how much of the system is in private hands.
To me there is no choice. I argue that the market should be allowed to determine who stays and who goes. What this will mean, however, is that more and more capital for American institutions will come from off shore. That is, the “wonderful” support for United States debt that has been accelerating in recent years, along with the decline in the value of the dollar, will lead to more and more foreign ownership of America’s assets.
Given this scenario, the major reason that might be given for a socialization of American finance is to keep it under American ownership, even if that ownership is coming from the government.
These two issues are the most important ones being faced in the current crisis. All the other things, to me, are secondary and should not muddy the waters of the debate going on.
ANOTHER ASIDE: I cannot agree with those that believe that this crisis was caused or exacerbated by “mark-to-market” accounting. I firmly believe in “mark-to-market” accounting because it increases the transparency of an institution’s decisions. Yes, it the market is moving around a lot there will be a lot of changes recorded on the balance sheet of a company, but, it was the management’s decision to have acquire such assets and the affect of these decisions should be obvious to shareholders and others. Riskier assets will require more marking to market. That is the choice of management. That choice should not be hidden.
Sunday, September 21, 2008
Thoughts on "The Plan"
Well, “The Plan” is becoming a reality. What exactly it is and whether or not it will be successful is still a mystery. That is not the issue at this point in time.
To me the important thing is the philosophy behind “The Plan”. Up to now the policy makers have been shooting at a moving target…and the target that they have been going for is usually behind where the market and the institutions are. Thus, the policy makers have always been behind the curve…and things keep getting worse.
Now a new effort is being made. I think that we can clearly see the hand of Fed Chairman Ben Bernanke behind this move. I think that Bernanke finally won the day with the AIG effort. Bernanke, the student of the Great Depression, finally convinced everyone that the only way to really stop the down draft that was going on was to get out in front of it…not keep shooting behind it.
That is, the action had to be big enough to overwhelm the debt deflation going on.
This is the lesson from the Great Depression. One cannot let the debt deflation continue to cumulate. One must get out ahead of it.
This doesn’t mean that such actions may not cause problems in the future…inflation, moral hazard, or whatever. None of these are the problem now. If such problems are present in the future then the future will just have to deal with them. First…we have to reach the future without a major collapse.
The concern now is that debt deflation will get out-of-hand and the problem will only grow with time. That is why the policy makers believe that it is necessary to create a big enough plan to get ahead of the cumulating debt deflation and do more than is necessary to stop the downward cycle.
Will it be big enough? Will it succeed? Who knows? This is decision making under uncertainty and we are way beyond graduate school!
The policymakers believe that this package will be enough. But, they don’t know that either. My sense is that they just believe that the package needs to be big enough to really have a chance to work.
If “The Plan” works will this be the end of the effort?
No, the effort will still be in its early stages. The financial system and its regulatory framework will have to be revamped. What this administration is doing is attempting to buy time by stopping the downward spiral of financial markets and financial institutions. It is not proposing a solution about how the system will move forward. That will be up to the next administration.
Nothing the Paulson/Bernanke team has done suggests how the financial system and its regulation should be re-structured. The Fannie Mae/Freddie Mac bailout did not do it. Nothing that has taken place since that action has done it. This will be the job of the next administration.
And, Congress should remember this and not try and make all sorts of additions to “The Plan”.
In terms of the next administration, I believe that the two presidential candidates need to put their new programs and plans, like universal health care, on the back burner. I don’t believe that they will have much of a chance to put any of their promises or polices into place for three or four years. They are going to have to create the brave new world and get things back into order before anything else can be put into place. Thus, the candidates need to put their campaign promises into their back pocket for another time. I don’t think that it really helps the situation to talk much about them.
The presidential candidates need to see what the current administration puts into place and then needs to try and build on this to construct a plan to get financial institutions and markets back on their feet, to revamp the regulatory system, and to devise an economic policy that is both realistic and builds confidence, nationally and internationally. This is what the candidates are going to have to sell…first to the people of the United States and then to the Congress of the United States and then to the rest of the world.
The Paulson/Bernanke plan has to have a chance to work. It is not going to help right now to have the candidates confuse the issue with second guessing and petty attacks. This is going to be a fine line to walk, but the nation needs to pull together right now to stop the downward spiral.
Just one other point on the activities of this last week: it was necessary to get the President out in front of the cameras and speak about the financial chaos to the world. For too long in the current financial meltdown the President’s absence has been noticeable. Now, the whole world has seen the President speak out. Unfortunately for him, the puppet strings were quite obvious and one could see Hank Paulson’s lips move as the President attempted to mouth the words that were being spoken. One only has to wonder how much of his administration was conducted in this way only with someone named Dick Chaney controlling the strings and mouthing the words.
To me the important thing is the philosophy behind “The Plan”. Up to now the policy makers have been shooting at a moving target…and the target that they have been going for is usually behind where the market and the institutions are. Thus, the policy makers have always been behind the curve…and things keep getting worse.
Now a new effort is being made. I think that we can clearly see the hand of Fed Chairman Ben Bernanke behind this move. I think that Bernanke finally won the day with the AIG effort. Bernanke, the student of the Great Depression, finally convinced everyone that the only way to really stop the down draft that was going on was to get out in front of it…not keep shooting behind it.
That is, the action had to be big enough to overwhelm the debt deflation going on.
This is the lesson from the Great Depression. One cannot let the debt deflation continue to cumulate. One must get out ahead of it.
This doesn’t mean that such actions may not cause problems in the future…inflation, moral hazard, or whatever. None of these are the problem now. If such problems are present in the future then the future will just have to deal with them. First…we have to reach the future without a major collapse.
The concern now is that debt deflation will get out-of-hand and the problem will only grow with time. That is why the policy makers believe that it is necessary to create a big enough plan to get ahead of the cumulating debt deflation and do more than is necessary to stop the downward cycle.
Will it be big enough? Will it succeed? Who knows? This is decision making under uncertainty and we are way beyond graduate school!
The policymakers believe that this package will be enough. But, they don’t know that either. My sense is that they just believe that the package needs to be big enough to really have a chance to work.
If “The Plan” works will this be the end of the effort?
No, the effort will still be in its early stages. The financial system and its regulatory framework will have to be revamped. What this administration is doing is attempting to buy time by stopping the downward spiral of financial markets and financial institutions. It is not proposing a solution about how the system will move forward. That will be up to the next administration.
Nothing the Paulson/Bernanke team has done suggests how the financial system and its regulation should be re-structured. The Fannie Mae/Freddie Mac bailout did not do it. Nothing that has taken place since that action has done it. This will be the job of the next administration.
And, Congress should remember this and not try and make all sorts of additions to “The Plan”.
In terms of the next administration, I believe that the two presidential candidates need to put their new programs and plans, like universal health care, on the back burner. I don’t believe that they will have much of a chance to put any of their promises or polices into place for three or four years. They are going to have to create the brave new world and get things back into order before anything else can be put into place. Thus, the candidates need to put their campaign promises into their back pocket for another time. I don’t think that it really helps the situation to talk much about them.
The presidential candidates need to see what the current administration puts into place and then needs to try and build on this to construct a plan to get financial institutions and markets back on their feet, to revamp the regulatory system, and to devise an economic policy that is both realistic and builds confidence, nationally and internationally. This is what the candidates are going to have to sell…first to the people of the United States and then to the Congress of the United States and then to the rest of the world.
The Paulson/Bernanke plan has to have a chance to work. It is not going to help right now to have the candidates confuse the issue with second guessing and petty attacks. This is going to be a fine line to walk, but the nation needs to pull together right now to stop the downward spiral.
Just one other point on the activities of this last week: it was necessary to get the President out in front of the cameras and speak about the financial chaos to the world. For too long in the current financial meltdown the President’s absence has been noticeable. Now, the whole world has seen the President speak out. Unfortunately for him, the puppet strings were quite obvious and one could see Hank Paulson’s lips move as the President attempted to mouth the words that were being spoken. One only has to wonder how much of his administration was conducted in this way only with someone named Dick Chaney controlling the strings and mouthing the words.
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