The fear of foreclosures and falling home prices is often an irrational fear. Obviously, the person losing his home may be fearful. Also, neighbors who wish to sell their own homes are nervous about low prices. However, most people have not budgeted around the notion of refinancing. Most people plan to stay in their homes for (say) another four years or more. For this vast majority there is no reason to fear foreclosures.
One of the troubling issues that arise during a recession, especially when we have arbitrary central bank monetary policy makers casting about looking for solutions to new problems is that there is a strong tendency to see inflation bandied about as a possible tool of monetary policy. RationalTheorist has looked at possible indicators of coming price inflation.
There are a couple of key reasons that inflation is considered as a policy tool. First, whether government officials believe in the value of inflation as a monetary policy, there is an implicit temptation to use inflationary policy to deal with the problems of financing massive government spending programs, such as the recent TARP, Obama stimulus package, and the FED’s various credit facilities. Inflation rewards those who hold debt, since an inflating money supply in the face of fixed debt payments means that debt loads shrink. A key problem that the FED has today is how it is going to issue enough debt in the form of Treasury bills in order to fund the stimulus programs. In addition, because asset values are inflated, any effort by the government to buy so-called “toxic assets” at prices that are too high will be ameliorated as the values of those assets would artificially inflate.
This temptation alone should give one concern about what might happen in the future. However, the second reason should give one even more concern. There are those who explicitly believe that inflationary policy is actually beneficial for the economy during a recession. Two examples have popped up recently in the media; one from a report of a Fed governor’s remarks, “FED’s Bullard: U.S. Facing Risk of Sustained Deflation” and the other from a Financial Times op-ed “Coordinated Inflation Could Bail Us All Out.” (free registration may be required)
The basic argument here is that monetary inflation (i.e. inflation of the money supply) can be used to combat a “deflationary trap” or deflationary spiral. The argument for a deflationary spiral says that due to a contraction in spending at the outset of a recession demand, and thus price, drops. However this leads to cutbacks and layoffs in the private sector and as a result, average incomes drop, and average debt levels actually rise. This in turn forces even more saving, with resultant demand drops and further cutbacks. This process is said to continue on in a spiral, eventually destroying the economy. This effect does happen during a recession, but I question its severity, and whether or not monetary inflation is proper to combat it.
In an economy that has been over-stimulated as ours has, a correction in asset values must occur. If we’ve been improperly subsidized to build too many houses over the last decade, then the price of housing must come down. Part of what we’re seeing is the market’s natural response to reset these asset values. This will hurt those who’ve over-estimated their ability to absorb risk (and should be a strong reminder why we don’t government interfering and creating distortions in the economy in the first place); however, it must occur. But the existence of falling asset values is its own stabilizer to continued fall because falling prices stimulates demand. Not everyone in the economy sees their incomes and asset values fall, and for those who do not, falling prices create an incentive to consume, thereby stabilizing deflationary pressures.
But the secondary and even more important issue here is that one cannot combat demand deflation with monetary inflation. Yes, inflating the money supply will cause prices to rise, seemingly reversing falling prices; however the mechanism of price movements are completely different in each case and one is not an antidote to the other. In a time of recession such as this where market distortions have resulted in the destruction of investment capital, what is needed is recapitalization. We need to use our current productive capability to accumulate savings (which if deposited become investment capital). Those who have over-borrowed need to pay down debt or sell off assets and their concurrent liabilities. Those who are in the best shape risk-wise can afford to spend, and those who are in worse shape should save and get rid of debt.
However, inflation destroys this process. Inflation destroys real wage levels, i.e. productive capability. It favors those who have large debts, and it destroys the value of accumulated assets. It is unjust. Those who have over-borrowed see their debts effectively forgiven. Those who were prudent and have saved see their assets destroyed.
Those who think that this sort of policy can be a good thing suffer from a form of macro-economic rationalism. That is, they view the economy as an aggregate machine, a sort of “black box.” They have correlated increasing money supply with rising prices and recession with falling prices and simply see one as a way to combat the other. Faced with a condition of falling prices, they know they can make prices rise by printing money. It is as if they are pulling levers and turning knobs on this black box simply to keep the gauges reading what they were. They care little what the fundamental mechanisms of each are. The articles I referenced show this.
From the WSJ blog:
Bullard also said a more systematic approach to countering deflation would entail more communication about what the Fed is trying to accomplish. He suggested setting “quantitative targets for monetary policy, beginning with the growth rate of the monetary base.”
“By expanding the monetary base at an appropriate rate, the FOMC [the Fed’s policy-making Federal Open Market Committee] can signal that it intends to avoid the risk of further deflation and the possibility of a deflation trap,” Bullard said.
In his comments on the economy, Bullard said “macroeconomic expectations are very fluid and volatile.” He added “the current recession is a global phenomenon” and “it seems likely that output and employment will continue to shrink in the first half of 2009.”
“There is a risk that core prices may continue to stagnate or decline slightly for some time to come,” Bullard said.
The article is devoid of any reference to what market prices should be, or any mechanisms of operation of the market. Output and employment are falling, therefore the FED should act to increase prices. The “gauge” does not read correctly therefore we have to pull this “lever” to make it do so.
Even more brazen or bizarre is the Financial Times article, where the author clearly advocates for an inflationary policy, after explicitly and correctly articulating the various positive effects of such a policy, while all but ignoring the negative effects.
It [an inflationary policy] would help government finances by inflating away 10 per cent of total government debt. This lowers the interest burden for future taxpayers. Since taxes are levied primarily on income, this has both equity and efficiency benefits. It is (more) equitable as the cost of recession will be borne by wealth holders as well as income generators, and it is (more) efficient in that it reduces the extent of incentive-reducing tax rises on income in the future.
Companies will benefit in two ways. First, a portion of their debt will disappear, with the benefit being the largest for those companies that have debts with fixed interest, such as corporate bonds.
Second, while real wages seem to be downwardly flexible, nominal wages are less so. Higher inflation allows more companies and workers to agree to real wage cuts than would otherwise be the case. This is both useful for those firms that are currently uncompetitive, and preferable for society, because wage cuts are more equitable than unemployment.
A rise in inflation also means that declines in real house prices translate into less negative equity, freeing up the housing market. This is beneficial for labour mobility and helpful to the real economy because additional house sales spur economic activity.
Banks would gain in three ways. Inflation reduces future bad debts by making debt servicing easier. It makes defaults less costly because real collateral is more likely to exceed nominal debt. Finally, it makes existing bad debts less onerous on the balance sheet. This reduces the need for government recapitalisations and “bad banks” and increases the ability of governments to sell recently acquired banks. This, in turn, reduces the debt burden on future taxpayers.
An extra 2 points of inflation for five years is not a “get out of jail free card”. Bank shareholders, rightly, will still lose greatly from their managers’ decisions. Future taxpayers will, inevitably, still bear most of the cost of counter-cyclical government spending.
It is not costless. Regrettably, prudent savers will see their assets reduced. That might be the price society has to pay to keep the banking system afloat without crippling future taxpayers.
In terms of direct costs, the negative effects are equal and opposite to the claimed benefits. For every dollar that a debt holder’s obligation is lessened, the capital lender is punished by an equal amount. To call that a “cost” is to suggest that when a thief steals from you, that your loss is simply a “cost” of the benefit he gains. When the costs equal the benefit, there is no benefit. The indirect costs however are even greater because it is the asset holders that will restart the economy and it is they who are punished in an inflationary environment. Inflation destroys the very process of recapitalization that the recession will facilitate if left alone!
The rising debt levels that the United States is experiencing should concern those who see it as a temptation on the part of regulators to use inflation to “finance” their efforts. However, when inflation is explicitly advocated as a monetary policy by those in power, it is all but sure to rear its ugly head. It can only prolong the recession.
Warren Buffet is not a supporter of a real free-market. He’s for a “mixed economy”, and thinks the government ought to be taxing him more, redistributing his money to the poor. He talks about an “ovarian lottery” being responsible for much of his own success (I guess he’s either read John Rawls, or simply picked it up second-hand). As a super-rich self-made man, he’s a prime example of the “sanction of the victim”, asking to be hurt. Neither is Buffet great on economics. Here too, he has bought in to a standard the Keynesian/Monetarist mixture.
So, when Buffet gives advice he’s not saying how we can get to a thriving free-market; rather, he’s really saying: “Here is how we can get to a more stable mixed economy that does not cross the line into stagnation or a downward spiral”. He did this yesterday, appearing on CNBC for a 3-hour special. Since he is somewhat influential, I thought some readers may be interested in what he said. There’s much to dislike in what Buffet says, but I want to present his views in this post; a critique can wait.
I’m going to paraphrase. Also, be warned that I’m going to read between the lines, but I do so with my full sense of honestly. [For what is probably a good transcript: see Gurufocus, but I got my summary from watching the show.]
With all those caveats, here is Warren Buffet’s advice to Obama:
Do not demonise people: Do not portray businessmen as evil. People are getting the impression that every big bank is like Citibank. This is false. If people act on that false assumption they’ll do the wrong things and ask for the wrong things to be done. This false impression destroys the very confidence we need at this point. [RT, using a Buffet example, but extending it: Imagine a set of generals launching the invasion of Normandy, and one general does something wrong. Now, imagine the President starts criticising generals as a group, commentators speak of “Main Street vs. Military Street”, while Congress starts holding hearings where general are called from the front to testify and then criticised for not flying back commercial. End-Aside] It is not fair, and it undermines good people. We need good people at times like this: we do not need villains, we need victories.
Drop all the other noble goals: Ever the altruist, Buffet thinks it’s a good long-term goal for the government to help people with health care and to raise taxes on the super-rich. However, he says, now is not the time. The idea of “not wanting to waste an emergency” is a poor notion; that’s like a president saying he does not want to waste a war. This is not the time to do things that the GOP is strongly against. For now, forget about health-care and about raising taxes on the rich. This is a time to focus on the single task at hand, with a sense of unity. You cannot expect unity on things people strongly disagree about. So, you have to drop that part of your agenda. Also, unity is not helped by demonizing people. Even the stimulus should not be the main focus: it should be all about fixing the financial system.
Some goals aren’t even worthy: Card-check is a bad idea. Secret ballot is a good idea for unions too. As for global warming, Buffet does not express an opinion. If we want to prevent carbon-emissions, he agrees that some type of tax will be required. However, we should be honest that this is a tax on consumers. He owns huge utility companies, and the state utility commissions will simply pass that tax on to consumers. His top men who run his utilities tell him that cap and trade is a bad idea.
Clarity and predictability are vital: It has been some months now and we do not have clarity on what the government will or will not do. People will stay partially paralyzed, waiting, until they see more clarity and predictability of direction. Smaller details of any plan do not matter as much as having a clear plan that people can count on, without the rules being changed on them. Also, one cannot get this clarity from lower officials. The president is the one who has to make the large strokes absolutely clear, by stating them and committing to them.
We’re mostly done enough: The previous administration stepped in and pushed money into banks, money-market funds and AIG. Buffet supports most of what was done. He thinks that the government should continue to guarantee bank deposits (even over the current $250k number) and also guarantee bank debt. However, he does not think banks need more government money. In his view, the most important thing is to create an environment where the good banks, like Wells Fargo, can grow their way out of this on their own. (Buffet is a large shareholder in Wells Fargo.)
Curtail “mark to market”: The biggest risk he sees to banks is if the government forces banks to take new capital at today’s low share-prices. The immediate cause will be if the government thinks the banks have too little capital. In turn, the immediate cause for that will be if the government uses “mark to market” to calculate that banks have too little capital.
Buffet is a strong supporter of “mark to market” for accounting. He thinks it should not only be reported in accounting footnotes, but should be the primary figure. Let management’s estimates be in the footnotes; and let shareholders decide whether to believe management. However, he also thinks the government should not use “mark to market” alone, when calculating legal capital requirements for banks during a panic. In a panic, that forces banks into being viewed as unrealistically worse than they really are. It creates the basis for government to put in more capital where no more is really required; and, in doing so, the government undermines private capital. Instead, the government should modify its (very recent) rules on using MTM to calculate capital-requirements and make them clear. While doing so, it should guarantee that if the capital turns out to be really inadequate, it will nevertheless guarantee depositors and bank-debt.
Finally, Buffet thinks the country will come out of this and grow to even wealthier times. However, the choice is between years of struggling and finally emerging despite government action, or having government set an environment that let’s banks and other companies to grow out of the current state more quickly.
RT again: That’s the summary.
Buffet is not making any call for radical change. He fully supports much that got us into this mess. He ignores much of the government-caused mess that brought us to where we are. In effect, he’s suggesting we fix things so that we leave something for the politicians to mess with. Buffet’s message is: don’t kill the goose that lays the golden egg. While he is no radical for capitalism, his interview basically makes the case that Obama should not be a radical anti-capitalist.
Yet, while there are many things to disagree with, I have to admit that when the general on the war-path is calling for business to be cut to shreds, it is heartening (in a “choose the lesser evil” way) to hear one sage from the general’s side say: “let’s just cut off a finger or two; we’ll have time enough to do the rest later when they stop wiggling”. Unless one thinks we must head to apocalypse first, it is a good sign that some voices are not so radical.
The answer: when we simply call it something else.
Nationalization of key large banks has been the talk for the past few weeks. This seems to be the dominant mechanism being discussed for a thorough restructuring of bank balance sheets. Harvard University economist Greg Mankiw suggests that in order to describe what is really meant by the process, you have to properly describe it.
If the government is to intervene in a big way to fix the banking system, “nationalization” is the wrong word because it suggests the wrong endgame. If banks are as insolvent as some analysts claim, then the goal should be a massive reorganization of these financial institutions. Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure.
Megan McArdle at The Atlantic.com adds,
If nationalization is just a way to take control of the downsizing and ensure that equity shareholders and creditors don’t profit at the expense of the taxpayer, all well and good. If it is a way to avoid recognizing the full extent of the losses as quickly as possible, not so much.
This confusion regarding what is meant by a possible nationalization highlights a key issue with the whole scheme. It doesn’t have a “playbook” or in other words there is no rule of law that covers the powers that must be exercised to complete such an action. If you are worried by the concept, you have a reason to be. It is because we have very little recourse against the arbitrary exercise of power should such action be taken.
This seems to be the biggest issue I have with those economists who are discussing the option. They discuss the mechanics of such action in the abstract, as if government is simply taking the role of a surgeon operating on his patient, rather than a political entity composed of conflicting ideologies and agendas devouring their kill.
The issue of politicization was taken up in a Wall Street Journal op-ed, “The Problem with ‘Nationalization’” last week. Given Washington’s track record of not doing what it started out claiming it would do in regard to the crisis, is there any reason to believe that what starts out as a “type of bankruptcy procedure” would not end up becoming institutionalized government encroachment in the financial sector?
From the beginning, the handling of the U.S. crisis has been politicized. The partisanship is as toxic as the bad assets on bank balance sheets. Both parties are coming up with schemes to impede the process of foreclosing on homeowners who can’t afford their homes, which would get those homes into the hands of new owners who can afford them. Does anyone believe that a government bad bank will squeeze homeowners? To ask the question is to answer it.
Moreover, we know how the government runs financial institutions — consider Fannie Mae and Freddie Mac. Or IndyMac, whose management by the FDIC has been criticized for inflating the rescue costs through its liberal loan-modification program. A money-center bank in government hands would become a conduit for politicized lending and grants disguised as loans. That’s what’s happened at Fannie and Freddie. The government would never let go of its political ATM. You might as well consolidate such an institution with the Fed from the outset.
Mr. Geithner wants a public-private partnership to buy toxic assets from banks. All that government has done thus far has only scared private money off. As bankers now realize, when you turn to the government for financial assistance you take on an untrustworthy partner. Outside money will not come in only to see its investment diluted later on when the government injects additional funds.
Rather than focusing on ways in which we can further involve the government in the financial system, we need to find ways to extricate banks from government’s deadly embrace. Banks, at least the behemoths, were public-private partnerships before the crisis. Deposit insurance, access to the Fed’s lending, and the implicit (now explicit) government guarantee for banks “too big to fail” all constituted a system of financial corporatism. It must be ended not extended.
While the government currently ‘nationalizes’ banks as part of FDIC’s mandate, former FDIC head William Isaac points out that nationalization of one of our largest institutions is far beyond the scope and complexity of any nationalization ever attempted by FDIC.
The fact is that there is a process already covered by the rule of law meant for such instances, Chapter 11 bankruptcy reorganization or Chapter 7 liquidation. Yves Smith at naked capitalism argues that this is not an option for these large banks.
It’s hard to convey to people outside finance why a big complicated bank isn’t the same as a manufacturing business or a retailer, where you can resort to Chapter 11. The simplest explanation may be that banks are much more tightly integrated into various customer and counterparty webs than most other businesses are. If a big automaker wants to shut down a production line for a few hours or a week. it can be done with little disruption to outside parties if planned. It isn’t acceptable for a trading desk to shut down for a day, say to do “routine maintenance”. Counterparties would run for the hills the next chance they had a chance to initiate trades. Now one might argue that this is convention, but as a customer, not being able to trade, not having ready access to one’s funds is seen as an unacceptable risk, and that business requirement makes it impossible to resort to Chapter 11.
The short explanation of Yves point is that banks are supposedly special beasts. For instance, when an airline goes into Chapter 11, people are still willing to fly. There’s not much chance on any given flight that the plane will take off without fuel. However, banks use your money as “fuel”,” and there is a chance that if you give your funds to one in Chapter 11 that you might never see them again. As a result, bank bankruptcy has a confidence problem and risks a potential run.
I don’t buy it. Citi today is almost certainly insolvent. Given the government’s arbitrary actions in dealing with each problem as it comes along, there is a high level of uncertainty that any one party will be kept whole in a government led restructuring. Yet Citi continues to do business.
The key here is that a bad bank still consist of healthy operations which can be sold off intact as part of bankruptcy proceedings. In a free market, investment capital would seek out clean, vetted acquisitions of healthy chunks of these banks. Proven management teams who can perform adequate due diligence would field this capital to acquire portions of these banks. This would result in orderly transfers and recapitalizations of healthy portions of these banks, under rule of law.
Nationalization by any other name is still nationalization, because it is an arbitrary act of government, and as such unpredictable and uncontrollable. Instead of increasing arbitrary involvement of government in the financial sector, we need less government intervention.