Depression Or Recovery -- What's In the Cards?

Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works
    —Mr. John Mills (1867), as cited by the London Banker

An economist is someone who has had a human being described to him, but has never actually seen one.
    —from Jokes about Economists

This essay analyzes the past, current and future state of the economy. I wrote this analysis to try to get a handle on what's going on and what we can expect. I hope others will find it useful. I am not an economist—some might consider that a virtue at this point—so any technical mistakes it contains are my own. Bear in mind that any mistakes I have made do not carry nearly the weight of the economic policy errors made by degreed professionals that got us into this mess to begin with.

Too Much Debt

Predicting the future performance of the American economy requires us to take the long view. Reuter's columnist John Kemp emphasizes the deep roots of today's financial crisis in U.S and U.K on brink of debt disaster (The Guardian, January 20, 2009). The problem is hugely inflated private sector indebtedness—a credit bubble—created over the last 30-odd years (Figure 2, with a quote).

       Figure 2 — History of nominal GDP, public and private debt in the U.S. Scale on left is $billions.

The United States and the United Kingdom stand on the brink of the largest debt crisis in history. While both governments experiment with quantitative easing, bad banks to absorb non-performing loans, and state guarantees to restart bank lending, the only real way out is some combination of widespread corporate default, debt write-downs and inflation to reduce the burden of debt to more manageable levels. Everything else is window-dressing.

The banking system consistently made over-leveraged bets on mortgage-backed securities by buying or selling derivatives just as they consistently—conveniently, as greed dictated—underestimated the risks in doing so, a process documented in Michael Lewis' The End. While it is easy to get lost in talk about sub-prime mortgages and a ponzi-scheme in derivatives built upon them as the proximate causes of the credit crisis, the Housing Bubble, and before that the Tech Bubble, owed their existence to an exponential expansion of credit that began in the 1970s. From Kemp—

In the 1960s and 1970s, total debt was rising at roughly the same rate as nominal GDP. By 2000-2007, total debt was rising almost twice as fast as output, with the rapid issuance all coming from the private sector, as well as state and local governments.This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion). The resulting debt was only sustainable so long as economic conditions remained extremely favorable. The sheer volume of private-sector obligations the economy was carrying implied an increasing vulnerability to any shock that changed the terms on which financing was available, or altered the underlying GDP cash flows.

It follows that each percent of GDP gained depended on an ever greater amount of debt accumulated. The shock that has "changed the terms on which financing is available and altered underlying cash flows" to businesses and individuals has now occurred.

I will focus briefly on consumer credit because it is a microcosm of the larger problem. Debt-financed American household spending, which has exceeded 70% of GDP in recent years, was based on consumer credit (like Visa cards) and inflated asset values in both housing and stocks (Figures 2 and 3).

 Figure 2 — Recent history of personal savings and household debt, from The Economist

  Figure 3 — Consumer credit as percentage of GDP, as cited by Mark Perry at Carpe Diem

Figure 3 is of particular interest in so far as the Federal Reserve lists consumer credit as covering "most short- and intermediate-term credit extended to individuals, excluding loans secured by real estate." Personal loans rose from slightly more than 12% of GDP in 1994 to 18.7% in 2003, but subsequently dropped back to 17.9% in the third quarter of 2008.  At the height of the madness during 2003-2005 when Figure 3 shows that  consumer credit as percent of GDP was falling, Americans were using their houses as ATM machines. From The Zero Savings Problem, CNNMoney, August 3, 2005—

Even as a government report Tuesday showed the national savings rate at zero — that's right nada — the rise in the value of homes has given the average U.S. household a net worth of greater than $400,000, according to a separate report from the Federal Reserve.

Household real estate assets have risen by just over two-thirds since 1999, and the run up has enabled consumers to spend more money than they are bringing home in their paychecks. They're viewing their homes almost like ATM's, using home equity loans and refinancings to pull out cash and support a higher level of spending.

[Full disclosure — I re-financed my Boulder, Colorado condo in 2004 and took some money out of equity before selling it in 2006.]

By mid-2008, with food and energy costs skyrocketing, Americans were putting those expenses on credit cards again. CNBC's Credit Card Use is Surging, Risking Another Debt Crisis (June 3, 2008) told the story. Remember, this was written before the meltdown in September and October.

Cash-strapped Americans are ringing up more and more purchases on their credit and debit cards, and there could be a steep price to pay ahead. Though the trend is a boon for the companies that issue the cards, analysts worry that there could be long-term problems not only for consumers but also for the anemic economy and the already-troubled banks that will be underwriting all that risky debt.

One of the main problems with that is US consumers—and their counterparts in Europe as well—already are delinquent on their credit card payments in numbers not seen in six years. The Federal Reserve last week said credit card delinquencies hit 4.86 percent in the first quarter in 2008, while revolving debt—or the type used in credit purchases—hit $957.2 billion in March, a 7.9 percent increase.

As all that risky, high-interest debt keeps accumulating, consumers will find themselves deeper in a hole that threatens to keep the economy in its sluggish state. Economists worry that the problems are being exacerbated by consumers using credit not only to buy big-screen TVs and patio furniture, but also to pay their mortgages and shop for groceries.

Delinquency was already rising as cash-strapped Americans paid their higher bills with plastic. Of course the banks had already created and sold risky derivatives based on credit cards debt (and student loans, etc.). Even last October the banks were making their debt problems worse as reported in Business Week's The Next Meltdown: Credit Card Debt (October, 9, 2008).

But some banks and credit-card companies may be exacerbating their problems. To boost profits and get ahead of coming regulation, they're hiking interest rates. But that's making it harder for consumers to keep up. That'll only make tomorrow's pain worse. Innovest estimates that credit-card issuers will take a $41 billion hit from rotten debt this year and a $96 billion blow in 2009.

Those losses, in turn, will wend their way through the $365 billion market for securities backed by credit-card debt. As with mortgages, banks bundle groups of so-called credit-card receivables, essentially consumers' outstanding balances, and sell them to big investors such as hedge funds and pension funds. Big issuers offload roughly 70% of their credit-card debt.

If we further analyzed the rise in private debt over the last 30 years shown in Figure 1, consumer credit would be just one slice of the explosive increase. Most of the focus recently has been on the indebtedness in the banking system due to "toxic" assets in the form of mortgage-backed securities.

This situation is about to get worse for banks as the value of bundled credit card assets begin to evaporate. Americans will pay down their credit card debt or default on it. Either way, they will be shopping less and card issuers face "permanently lower equity returns." American Express just reported that their fourth quarter earnings in 2008 were down 79% compared to 2007. 

"We remain cautious about the economic outlook through 2009, and expect cardmember spending to remain soft with past-due loans and write-offs rising from current levels," Chief Executive Kenneth Chenault said in a statement.

American Express has no doubt bundled up and sold most of their "credit-card receivables" to hedge funds and pension funds. Mark-to-market anyone?

Nouriel Roubini's latest analysis shows that the banking system is effectively insolvent (Bloomberg, January, 20, 2009).

U.S. financial losses from the credit crisis may reach $3.6 trillion, suggesting the banking system is “effectively insolvent,” said New York University Professor Nouriel Roubini, who predicted last year’s economic crisis.

“U.S. banks and broker dealers are estimated to incur about half of these losses, or $1.8 trillion ($1-1.1 trillion loan losses and $600-700bn in securities write-downs) as 40% of securitizations are assumed to be held abroad. The $1.8 trillion figure compares to banks and broker dealers capital of $1.4 trillion as of Q3 of 2008, leaving the banking system borderline insolvent even if write-downs on securitizations are excluded.”

[In the 2nd paragraph, Roubini is quoted from John Mauldin's financial newsletter Here comes TARP 3 and 4]

These credit dislocations, which have now spilled over from Wall Street onto Main Street, have now exposed our economy as a house of cards because the immense private debt can no longer be serviced and thus must be paid down, defaulted on or inflated away. As Kemp notes, there are ultimately only two ways to reduce private debt if the government can not accelerate the real rate of GDP growth—bankruptcy or inflation.

The economist Irving Fisher related over-indebtedness to depressions in his 1933 essay Debt-Deflation Theory of Great Depressions. Here is Fisher talking about debt and bubbles—

Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts...

[Author's Note—Fisher's "inventions and technological improvements" in modern times include (but are not limited) to personal credit cards, the internet, low risk quantitative models, liar and other types of sub-prime loans and derivatives of all sorts, but especially asset-backed credit derivatives, e.g. collateralized debt obligations (CDOs), structured investment vehicles (SIVs) and credit default swaps (CDSs).]

The public [or a bankers'] psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realizing a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible.

As Kemp points out, "widespread bankruptcies are probably socially and politically unacceptable." If widespread bankruptcies are unacceptable, that leaves us with inflation, to which we now turn.

The Debt-Deflation Theory of Depressions

Evaluating where we stand requires us to understand what the main job of the Federal Reserve is. The U.S. Central Bank is a regulator of inflation, which is usually thought of as a positive number. For the Fed, Public Enemy #1 is deflation, which is defined at Wikipedia—

Deflation in economics is a persistent decrease in the general price level of goods and services, when inflation is below zero percent, resulting in an increase in the real value of money - a negative inflation rate. When the inflation rate slows down (decreases, but remains positive), this is known as disinflation.

As we shall see, inflation (and hence deflation) can also be defined in terms of the money supply, which makes a difference to how analysts view the current situation. Some say we are threatened by a long-lived deflation, some say the real threat—or cure, depending on how you view it—is (positive) inflation.

The renewed relevance of Fisher's debt-deflation theory is explored in articles by Stephen Lendman (in Excess Debt and Deflation = Depression, Global Research, December 12, 2008) and the London Banker (in Fisher's Debt-Deflation Theory of Depressions, July 31, 2008). Quotes below are from Fisher or one of these two sources.

The cause of the current crisis was a very long period of expanded credit that "fueled speculation and asset bubbles" leading to over-indebtedness both on Wall Street and Main Street. When the latest bubble bursts, which began when house values starting falling in 2006, a predictable chain of events ensues. Fisher described this process:

1. Over-indebtedness leads to liquidation "through the alarm either of debtors or creditors or both"
2. "Debt liquidation leads to distress selling and to
3. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation."  Deposit and velocity contraction (from distress sales) cause
4. "a fall in the level of prices, in other words, a swelling of the dollar." If price declines aren't "interfered with by reflation or otherwise, there must be
5. A still greater fall in the net worths of business, precipitating bankruptcies and
6. a like fall in profits." That, in turn, causes
7. "A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
8. Hoarding and slowing down still more the velocity of circulation."

[Fisher's "velocity" refers to the rate at which money circulates, changes hands, or turns over. Greater velocity means greater demand and faster growth. It's computed by dividing the output of goods and services (GDP) by the total money supply].

These eight changes lead to "complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real ... rates of interest." The real interest rate is determined by subtracting the inflation rate (the CPI) from the nominal interest rate.

Adjusted real interest rates determine whether it makes sense to (1) borrow & spend or (2) save & pay down debt because they measure the real cost of borrowing. When real interest rates are lower than nominal rates in normal times, implying a positive level of inflation, it is advantageous to borrow and spend because future money is worth less than money today. In extreme cases, real interest rates turn negative as they did early in 2008.

In a debt-deflation economy, just the opposite holds true—real rates are higher than lowered nominal rates because the inflation rate is negative (= deflation), so it makes more sense to save and & pay down your debt. As Fisher pointed out, the "swelling" dollar buys more as time goes on so it is prudent to hunt for bargains down the road rather than spend money now. The "velocity of money" is contracting, both from the bottom-up (consumer spending) and the top-down (frozen credit markets). Hence the automobile industry is in serious trouble because few are buying new cars and trucks and often can't get loans to buy them even if they want to (Figure 4). Thus both the production of new cars and their price is falling.

Figure 4 — An ocean of unsold inventory

When many are selling (or defaulting) to offload their debt—called de-leveraging in modern parlance—"asset prices fall faster than the number of dollars owed shrinks" according to Fisher. As a result, "liquidation doesn't liquidate; it aggravates debts" and thus Fisher concludes that "the depression grows worse instead of better."

This phenomenon has been called the paradox of de-leveraging or alternatively, the "paradox of thrift." What might benefit the individual (greater savings) may not benefit the economy as a whole. That seems to imply that "Shop 'Till You Drop" is really the right thing to do regardless of your personal balance sheet. I shall have more to say about this in the last section.

At this juncture we need to determine where we stand today with respect to a debt-deflation economy, that is, a full-blown early 1930's-style depression.

Where Do We Stand?

Inflation is the slowest since 1954 (Wall Street Journal, January 16, 2008).

U.S. consumer prices barely rose last year by their slowest pace in over a half century, a government report showed, a stunning turn just a few months after inflation hit 17-year highs.

Much of the reversal was due to a roughly 75% decline in oil prices from their July peak that has in turn brought prices down for everything from gasoline and home heating to airline fares.

But some of inflation's disappearance is also a consequence of the severe economic recession that is causing nervous households to delay spending, which in its worst form could lead to the type of deflationary spiral that gripped Japan in the 1990s.

Consumer prices rose just 0.1% compared to December 2007, the lowest calendar-year increase since 1954 and well below the Fed's 1.5% to 2% preference over the long run...

The seasonally adjusted Consumer Price Index (CPI-U SA) declined in 4 of the last 5 months of 2008 and was never positive (Figure 5).

    Figure 5 — Recent history of the CPI-U (SA), month-over-month percent change

I should emphasize again that oil prices have been by far the single biggest driver of the current deflation, or disinflation, if you use the non-seasonally adjusted CPI-U cited by the Bureau of Labor Statistics. It's too early to tell whether deflation will take hold' but we are closer to the beginning than the end of this crisis. Again from the Wall Street Journal—

Some Wall Street economists think changes in the CPI will soon turn negative on an annual basis given the weakness of the economy and the sharp increases that occurred in early 2008.

"We will have to wait a further month before we get headline deflation," said ING Bank economist Rob Carnell, in a note to clients. "But it is coming and may get down to as low as -3%" on an annual basis unless oil prices reverse their recent declines, he said.

It is hard to come up with a short-term scenario in which oil prices will reverse their recent decline although OPEC is struggling mightily to reverse the trend. Other statistics strengthen the debt-deflation case. The outstanding household credit market debt in the United States (Figure 6) declined for the first time since measurements began in 1953, the same year the New York Yankees defeated the Brooklyn Dodgers to win the world series. The total amount of such debt declined from $13943.56 billion in April, 2008 to 13914.22 in July. Imagine where that number is now in January, 2009.

Figure 6 — History of the Household Credit Market Debt (CMDEBT), month-over-month percent  change. Gray bars are recessions. Source: St Louis Fed

itulip's Eric Janszen cites some grim statistics for 2008 in The Myth of the Slow Crash Revisited (January 9, 2009).

Every single working day in the month of December 2008:

• 190 U.S. companies filed for Chapter 7 or Chapter 11 bankruptcy protection
• 4,950 Individuals filed for bankruptcy protection
• 3,100 Homes went into foreclosure
• 26,190 Jobs were lost and 25,035 workers filed for unemployment insurance

For the year 2008, the $6.9 trillion in lost stock market value among 110 million households represents a per household loss of $62,727. The $6 trillion in lost residential real estate property value nationally in 2008 adds $54,545 per household for a total of $117,272 in lost household asset value in 2008, exceeding by 27% the national household median net worth in 2007 of $86,000. (Losses were concentrated in the middle quintiles aka "the middle class.")

This is starting to look very much like a 1929-1933 debt-deflation. Bad news on layoffs, housing, retail sales—you name it—is pouring in every day. The Fed and government officials are not ready to throw in the towel just yet, however. They've still got plenty of arrows left to shoot in their anti-deflation quiver.

The Money Supply, Actions of the Fed

You will recall that Irving Fisher's debt-deflation story says "... velocity contraction (from distress sales) causes a fall in the level of prices, in other words, a swelling of the dollar, if price declines aren't interfered with by reflation." Whether you see deflation or inflation in the cards depends on how you interpret Figure 7 and Figure 8.

 Figure 7 — Very recent history of money aggregates, from the American Institute for Economic Research (AIER)

 Figure 8 — Very recent history of the Fed balance sheet (assets), from Hamilton's Econbrowser

The simplest definition of inflation relates it to the aggregate money supply. From AIER—

Since the time of Adam Smith, economists generally have defined inflation or deflation as a rise or fall in the money supply (broadly defined). Whether or not such a monetary change brings about a rise or fall in the general level of prices will depend on people’s demand to hold money relative to the increase in the supply of money.

The M1 and M2 money aggregates (Figure 7) are explained in Is the Fed's rapidly expanding balance sheet an inflation threat? from Desjardins Economic Studies (January 15, 2009).

The amount of money in an economy (money supply) is not limited to the amount of bank notes and coins that are in circulation. It includes all of the money—currency in circulation and electronic scrip (electronic cash transactions)—that could be used as a means of payment. To currency, therefore, we must add the value of amounts held as demand deposits. This definition corresponds to the M1 monetary aggregate. Other monetary aggregates with broader definitions can also be calculated, including the M2, which is the M1 plus savings deposits, some term deposits and money market deposit accounts for individuals.

According to the St. Louis Fed, the adjusted monetary base is—

... an index that measures the effects on a central bank’s balance sheet of its open market operations, discount window lending, unsterilized foreign exchange market intervention, and changes in statutory reserve requirements. Such an index is important because the long-run path of a monetary economy’s price level is primarily determined by the path of the central bank’s balance sheet, adjusted for the effects of changes in statutory reserve requirements.

In the period 1930-1933 during the Great Depression, the M2 contracted each year. But as you can see in Figure 7, the M2 has been rising. Ergo, the thinking goes, we are not in a period of deflation. Instead, we have a heightened inflation risk when economic conditions normalize.

Contrary to some readings of situation, mainstream economists do not see the huge expansion of the Fed's balance sheet (Figure 8) as inflationary (as of yet) because the Central Bank has mostly borrowed the new money instead of printing it (James Hamilton, Econbrowser, December 21, 2008). With credit available from private banks slowing, the Fed has become the bank and lender of last resort. The First Trust article Fed Balance Sheet Expansion Is Not Hyper-Inflationary explains what is happening—

Borrowing money to increase the [Fed's] balance sheet does not increase the money supply. At the end of this piece are charts depicting the various components of the Fed’s balance sheet – both assets and liabilities. Analyzing the detail of that data shows that 90.3% of the expansion in the Fed’s balance sheet reflects borrowing from the Treasury, or from banks (now that the Fed pays interest on reserve deposits).

Why is the Fed boosting its balance sheet by borrowing? To temporarily fulfill the role of banks, who are much less willing to hold risky assets...

But, as economic problems spread [and the banks slowed lending] ... the Fed stepped into the gap. Now, banks hold their reserves at the Fed, and the Fed buys the commercial paper and other assets.

Although the Fed is not printing money to excess as some fear, the new loans they are making will end up as liabilities for the Treasury (and the public) if those loans do not perform well. Hamilton explains—

And what's the risk associated with the Fed's new strategy? Back when the Fed held $800 billion in Treasuries, these were a liability of the Treasury and an asset of the Fed. In effect, the Treasury's nominal obligation was one for which taxpayers would never owe a dime. Now that more than half of those securities have been lent or sold off by the Fed, and the Treasury has borrowed a half-trillion extra to make this work, that's more than a trillion extra for which the taxpayers are potentially on the line. If the loans and other assets that the Fed has acquired with those funds do not make a loss, then all is still well and good. But if the Fed's new loans do not perform, there won't be a positive receipt in the Monthly Treasury Statement corresponding to interest returned from the Fed to the Treasury. In other words, the federal deficit will rise by the amount of the extra interest the Treasury owes on up to a trillion dollars in new debt.

A recent article Fed Grapples With A New Risk Reality (Wall Street Journal, January 20, 2008) highlighted what can go wrong.

It has loads of subprime-mortgage bonds, souring commercial real-estate debt and collateralized debt obligations worth a fraction of their original value. This isn't Citigroup Inc. or Merrill Lynch. It is the Federal Reserve.

In the past year, the Fed lent out more than $1 trillion in its efforts to stabilize the financial and credit markets. A chunk of that was used to buy mortgage-related securities and loans in the rescues of Bear Stearns Cos. and American International Group, Inc. (AIG), as well as other debt shunned by investors...

The Fed's lending could swell by another $1 trillion or more in 2009 as its liquidity programs are tapped further by borrowers and it purchases more bonds, such as those issued by Fannie Mae and Freddie Mac, as well as securities backed by student loans, auto loans, credit-card receivables and small-business loans...

"Ultimately, the risk is to taxpayers," said Sung-Won Sohn, an economics professor at California State University, Channel Islands. "There's no guarantee the Fed is going to get its money back, and it's quite possible it could incur losses from the assets on its books, either from defaults or price depreciation, and Treasury or taxpayers would have to make up for them."

The Fed claims they screen the collateral carefully, some of which is subject to "haircuts" i.e. adjustments to the amount the Fed lends for risky pledged assets. If the Fed's gamble doesn't work out, taxpayers will be on the hook for a lot of money. Ultimately, this may not matter to the Fed or the Treasury because running large Federal deficits is seen as just another strategy for fending off deflation  (see below). It's still far too early to evaluate the performance of the Fed. One thing's for sure: they're doing a lot of stuff they've never tried before and they're not done.

The bottom line is this: if the Fed had not stepped in to grease the wheels of commerce and support the money supply, the credit crunch would certainly have eroded it in a repeat of 1930. As the Desjardin analysis states, normally "banks excess reserves are used to make new loans, which results in increasing the money supply... Financial institutions do not want to make as many loans as they once did, preferring to keep more in reserve [at the Fed]. This change in behavior has a big effect on the money creation process, by reducing the money multiplier."

So money is being created at a slower rate than it normally would be, but without any increase in aggregate demand and output (GDP), and with asset values (housing) still falling, Fisher's velocity (turnover rate) of money continues to decline (fueling deflation) despite the Fed's expanded balance sheet. It is also absurd to say that effectively insolvent banks do not want to make as many loans as they did before. Thus troubled banks like Citigroup take in TARP money without lending it out to partially mend their broken balance sheets (Wall Street Journal, January 26, 2008).

In the general debate about whether deflation or inflation is in the cards, it is a matter of how long deflation will be in effect. No one doubts that the inflation rate will become positive again, it is a question of when. The Fed does not even admit the possibility of a long-lived deflation—they are in the expectations business.

Reuters' Fed, ECP prepare to tackle deflation head-on reported on remarks by Janet Yellen, head of the Federal Reserve Bank of San Francisco (January 4, 2009).

"It is increasingly likely that inflation will fall to undesirably low levels," Yellen said at the meeting in San Francisco... In both speeches on Sunday Yellen's highlighted a risk that, as inflation expectations fall and benchmark rates are held near zero, "real" interest rates will actually rise, at the worst possible time.

"A decline in inflationary expectations when economic conditions are weak is pernicious ... because any down-drift in inflation expectations leads to an up-drift in real interest rates and a tightening of financial conditions," she said. [emphasis added]

Note that Yellen refers to falling "inflationary expectations" (twice) and does not mention "deflation" at all. That will turn out to be important as we turn to the future in the next section. You will have little luck finding a Fed official willing to admit that a dreaded debt-deflation spiral is upon us. In his Stamp Lecture at the London School of Economics on January 13, 2009, Ben Bernanke noted that—

At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.

Inflation will "continue to moderate." Other recent code phrases for deflation include "downward pressure on inflation" and "the prospect for inflation to persist below rates that best foster economic growth and price stability in the long-term."

Other economists are more adamant that an extended period of debt-deflation will be avoided. Here's what Goldman Sachs' Abbey Joseph Cohen, who is at liberty to mention the dreaded "D" word because she does not work for the Fed, had to say about it—

"Our belief is that we are not entering a period of dramatic deflation. We do not think this will be the 1930s revisited," she said. "A true deflation is when incomes deflate not just for a few quarters, as we expect, but for a multi-year period."

Cohen said her firm predicted that the recession would end in six months or so, at least in terms of declining gross domestic product.

And now we come to the crux of the matter. How and when will reflation of the economy come about? Does anybody know what they're doing here?

Reflating the Economy

The United States officially went into recession in December, 2007. The other G8 nations are also all in recession and growth in the BRIC countries is slowing (China) or non-existent (Russia). Fiscal and monetary measures to stimulate the economy started in early 2008 and continue at an accelerating pace today. On November 24, Bloomberg assessed all financial pledges at $7.76 trillion, a figure which included government programs like the TARP, the Fed's expanded balance sheet, FDIC liquidity guarantees, and the FHA's Hope For Homeowners.

If we provisionally accept Bloomberg's $7.76 trillion number, guaranteed expenditures amount to $25,541 for each man, woman and child in the United States. Writing a check for that amount (less processing expenses) would appear to be the most efficient way to stimulate the economy since consumer spending makes up over 70% of GDP—my tongue is firmly in my cheek here. Needless to say we will not be going down this road. Empires in decline do not operate this way.

Here's an overview of what has happened and what we can expect as fiscal & monetary actions are deployed to fight deflation. See Bloomberg's story for the details as of last November.

1. Plan A — monetary interest rate stimulus (FAILED). The Fed lowered the funds target rate repeatedly in 2008, reaching the zero-bound in December (Figure 9 below).
2. Plan B — expanding the Fed balance sheet (Figure 8), liquidity injections from first half of the TARP ($350 billion), other guarantees (FAILED)
3. Plan C — new or additional draws on loan guarantees (e.g. by Fannie Mae and Freddie Mac), 2nd half of the TARP, further expansion of the Fed's balance sheet, Obama's $825 billion stimulus plan? (IN PROGRESS)
4. Plan  D — A "bad" bank? TARP 2? TARP 3? Extraordinary Fed and government actions justified by economic theory as explained below (SPECULATIVE)

The United States is now embarking on Plan C. With Plan A having failed, almost all subsequent measures seek to alleviate private indebtedness in the insolvent banking system by creating public debt. It is too early to assess what the size of that debt will be, just as it is too early to gauge what the Fed's balance sheet will look like in one or two years time. The goal is to foreshorten the period of deflation by creating inflation expectations, thus lowering real interest rates and reflating the economy.

When Bernanke, Yellen and other Fed spokesmen downplay the debt-deflation problem by pronouncing that inflation will continue to "moderate" or other euphemistic claptrap, we should bear in mind that these officials are fully aware of the scope of the crisis. If things were not out of hand, the force of economic measures being deployed to stem the deflationary tide would be grossly disproportionate to the circumstances.

It was a sign of real trouble ahead when the monetary stimulus (Plan A) to borrowing & spending, which created negative real interest rates early in 2008, failed to work its magic. Bloomberg's Fed May Cut Rate Below Inflation, Risking Bubbles worried that the central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later! The time to fret about low benchmark rates was between 2002 and mid-2004 when Alan Greenspan put the spurs to an already bubbly housing market (Figure 9).

Figure 9 — Recent History of the Fed Funds Rate

The Fed Funds Target Rate finally hit the zero-bound in December. Economists refer to this situation as a Liquidity Trap. Monetary Policy in a Zero-Interest-Rate Economy explains the problem that occurs in a liquidity trap (Federal Reserve Bank of Dallas, May, 2003).

Usually, the Fed attacks weakness in the economy by conducting expansionary open market
operations... Unfortunately, conventional open market operations lose their effectiveness as the yield on Treasury bills is driven to zero. At a zero interest rate, a Treasury bill is no different from vault cash or large-denomination currency. An open-market operation is like the Fed offering to exchange twenty $1 bills for one $20 bill: The increase in liquidity is negligible.

Once you've hit the zero-bound, things turn particularly ugly if there is deflation because real interest rates above nominal rates discourages investment and spending—

Policy-makers can find themselves in serious trouble if they come up against the zero interest-rate bound during a period of falling prices—that is, during a period of deflation. That’s because what ultimately matters to households and firms is the real cost of borrowing—what economists call the real interest rate...

For example, if prices fall at a 3 percent annual rate, then a zero nominal interest rate puts the real cost of borrowing at a positive 3 percent. The prospect of a 3-percent real interest rate might be just fine in a healthy, growing economy. It will be excessive, however, in an economy where the growth outlook is poor, or where fragile finances have led households and firms to become cautious about spending and banks to become cautious about lending.

Let there be no doubt that Bernanke, Geithner, Summers & Company believe they can reflate the economy sooner than later. Monetary Policy in a Zero Interest-Rate Economy, which Eric Janzsen refers to as the Fed's deflation playbook, lays out three methods by which the Fed, with the cooperation of government fiscal policy, can fight deflation in a liquidity (zero-interest rate) trap. We are now discussing Plan C and Plan D.

1. The foreign exchange escape route — In this approach, the Fed would pursue a targeted, substantial depreciation of the U.S. dollar, by purchasing foreign currency using newly minted dollars...

2. The goods & services solution — Why not have the Fed just conduct an open market purchase of real goods and services? Even more so than exchange rate intervention, this strategy would represent a direct stimulus to aggregate demand...

3. Buying other domestic securities — Even if the short riskless rate is equal to zero, other interest rates on other securities will generally be positive, and those securities could be targets for open market operations.

Regarding option #2, the Monetary Policy document elaborates as follows—

The strategy can be implemented, however, by coordination with fiscal policy-makers. The Federal government, for example, could purchase goods and services and finance the purchases with new debt, which the Fed in turn would buy–in technical terminology, the Fed would ‘monetize’ the resulting debt.

By coordinating with fiscal policy, the Fed could even implement what is essentially the classic textbook policy of dropping freshly printed money from a helicopter. In this case, the Fed would monetize government debt that had been issued to finance a tax cut. [the Fed document includes the picture]

The Fed's blueprint for fighting deflation finds justification in economic theory. Mick Phoenix, writing at The Market Oracle and The Collection Agency, has looked at some of the large literature on inflation, deflation and the Great Depression. One paper that caught Phoenix's eye has the interesting title How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible. Eggertsson wrote it for the IMF in 2003, but has since joined the New York Fed, which until very recently was the home our new Secretary of the Treasury. Phoenix is convinced that a copy of this paper sits on Bernanke's desk.

Theoretical academic issues (e.g. John Maynard Keynes vs. Milton Friedman) aside, it is possible to get a feel for the kind of desperate measures the Federal Government and the Central Bank might deploy to avoid a 2nd Great Depression. From Eggertsson—

Proposition 4 Committing to Being Irresponsible. If the central bank and the treasury coordinate policy to maximize social welfare, a government can commit to future inflation in a liquidity trap by cutting taxes and issuing nominal debt. Inflation is highest as the economy emerges from the liquidity trap. It declines with public debt over the infinite horizon and converges to zero in the absence of other shocks.

Propositions 5 (optimality of irresponsibility) and 6 (optimality of buying real assets) summarize the central results of this paper. Even if the government can not make commitment about future policy, it can control the price policy at zero nominal interest rates. A simple way to increase inflation expectations [and so promote borrowing and spending] is to coordinate fiscal and monetary policy and run budget deficits. This increases output and prices. The channel [method] is simple. Budget deficits generate nominal debt. Nominal debt in turn makes a higher inflation target in the future credible because the real value increases if the government reneges on the target. Higher inflation expectations lower the real rate of interest and thus stimulate aggregate demand. This policy involves direct actions by the government as opposed to only announcements about future policies. The government can announce an inflation target and then increase budge deficits until the target is reached.

An inflation target is now being floated by Fed officials. James Hamilton suggested setting a 3% inflation target back in December. we do need some inflation, but if a lot of this strikes you as "irresponsible", you are not alone. Nevertheless, Eggertsson niftily defines the lengths to which the government and the Fed will go to reflate the economy. There is no doubt they can do so. It is only a matter of time.

Final Thoughts

As a result of the 30-year credit bubble in the private sector (Figure 1), the U.S.economy is structurally unsound. If it were not, we would not be threatened with an extended period of deflation as the debt is wound down. The Housing Bubble and irresponsible risks taken by the banking system are merely the latest & greatest manifestations of modes of behavior that have been in effect, and encouraged, for decades. Now we face the threat of irresponsible debt creation in the public sector.

If the economy is a House of Cards because of the debt overhang, then how much sense does it make reflate it if there is no solid plan for putting it on a sound basis? Eggertsson uses the phrase "maximize social welfare". No doubt the Federal Government and the Central Bank see this as their primary mission, but will it maximize the social welfare if we don't (1) get rid of the debt and (2) start to make sound investments in things of real lasting value instead of John Mills' "unproductive works". Solar panels on your roof are a sound investment that nets real returns over time. Buying and selling asset-backed credit derivatives are not. Unfortunately, consumers spent most of the borrowed money on flat screen TVs, SUVs and energy-inefficient McMansions, not more productive investments. All this time the U.S. manufacturing base was disappearing and good jobs were shipped overseas.

Putting our economy on a sound basis entails an inevitable slowdown in economic activity and gradual rebuilding of the economy once the bottom is reached. This would take years to accomplish, but the Powers That Be are anxious to reflate the economy now in an attempt to avoid the pain of such a transformation.Thus Anatole Kaletsky, who fears the "paradox of thrift", argues that it is appropriate to punish savers and make them spend money. How would that maximize the social welfare? It would not. Whose welfare are we talking about here?

Any attempt to avoid the pain will likely fail. All you are really accomplishing is a postponement unless productive investments (e.g. in energy infrastructure) are made once the economy is reflated. Our choices are thus clear—more bubbles and crashes or a slowdown, transformation and a commitment to productive works.

Contact the author at dave.aspo@gmail.com

Comments

[Yair]

Dear Dave Cohen
I am delighted to find your blog, I always enjoy reading your pieces, they're sharp and illuminating, and help to make sense of quite complicated issues.

You may be familiar with ex-TOD writers Stoneleigh and Ilargi's predictions, as set out in their Automatic Earth blog. In a nutshell, they say: bank losses on derivaties will be too big to recapitalise; their "assets" are worth close to nothing, and will be worth even less as house prices continue to plummet; deflation will take hold, and will have to run its course for some years before inflation returns, and in the meantime the price to the economy and society will be a major "discontinuity" (this is my term, not theirs). The Automatic Earth has a good track record on predicting this crisis, although past performance is no indication of future returns....

The fact is that as you say, these FED measures have not been tried before. What if they fail? That is, what if the psychological spiral-down effect is much stronger than attempts to monetise debt? So far the Fed and government (or here in the UK government+Bank of England) have been behind the curve. Yet you seem to believe that a full blown depression can be averted with high likelihood. Is this correct?
YW

[Rob]

This was an excellent article.

Thanks for writing it up. I'm just learning about all this stuff, and your article definitely pointed to some valuable resources.