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What's going on with the economy?
Paul Krugman runs through some basic scenarios. Remember when Philip Cagan asked why open market operations are performed in terms of money and T-Bills rather than other assets?
The final whammy may be this: the socialist calculation debate (remember that?) is now working against rather than for recovery. Market prices communicate vital information but that assumes a critical mass of market participants is actually trading. When trading dries up, prices go away. When prices go away, the costs of trading rise and fewer people wish to trade.
Felix Salmon notes:
My feeling is that the credit markets are hysterical. They're not clearing, they're not acting efficiently, and spreads, especially on highly-rated debt, are much higher than credit risk alone could ever account for.
Trading in junk bonds hasn't been "right" since the fall. Many of the markets for short-term debt securities are becoming illiquid as well. Why markets are self-destructing in this way remains a puzzle; dump on markets all you want but why here and now?
Loyal MR readers will know that I am usually an economic optimist but at the moment I am worried. I don't see the so-called "real side" of the economy as intolerable by any means. But a weird financial dynamic seems to be feeding on itself in an unusually violent fashion. Steve Waldman has an insightful albeit overstated argument; consider this:
The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity.
Is/was the subprime crisis simply a mask for a more general revaluation of the meaning and extent of liquidity? Are such revaluations always so bumpy and so lacking in locally stable iterative processes? As the Chinese would say, we live in interesting times.
Posted by Tyler Cowen on March 8, 2008 at 11:20 PM in Economics | Permalink
Comments
Krugman cites Steve Randy Waldman's Interfluidity blog. In an earlier blog posting of his, Waldman makes a distinction between a panic and a reckoning. Bailouts won't help if we are facing a reckoning.
Similiar, Nouriel Roubini has often made the distinction between a mere liquidity crisis and a solvency crisis.
Posted by: at Mar 9, 2008 12:00:04 AM
Isn't a bubble precisely something where economic calculation goes awry? If prices were giving the correct signals to lenders, borrowers and home-builders, how could a bubble have formed in the first place? It seems to me that the "boom" phase was the one where credit (and house) markets went hysterical. Why else would price signals have gone so screwy?
From what I understand, there is a lot of uncertainty in bond markets, because people are just unsure of how safe of investments their bonds are. Wouldn't illiquidity be a normal, and constructive, response to this sort of uncertainty?
Posted by: Grant at Mar 9, 2008 12:02:26 AM
The system is losing enormous amounts of liquidity. It is coming out of niches that make it very hard to replace through traditional monetary policy actions. The common thread is the withdrawal of liquidity from highly rated but non-transparent funding markets. These are not the subprime markets but were taken down by the collapse of subprime securities and the (justified) loss of reliance on the rating agencies.
1. The asset backed cp market is simply going away. This is taking $1T out of the banking system. The money fund assets that had been in this market are not being reinvested within the banking system, most is going into T-bills. This is an invisible bank run we have been living through since August.
2. Most providers of consumer and commercial credit have come to rely explicitly on securitization as their ultimate source of liquidity. There is practically no access to funds available in this market, and it is the highest rated end where the liquidity is worst. The banks weren't really capable of replacing these markets as a funding source even without their own funding crises to address.
To put this as simply as I can, the main providers of liquidity within the financial system -- money market investors and other providers of liquid cash -- are not built to take credit or liquidity risk. Yet the system developed such that they were, through extendible ABCP, auction rate notes, etc, all backed non-transparently by instruments with all kinds of credit risk and liquidity that was chancy in the best of times. Now that this risk is evident, all these investors can do at this time is to withdraw from the markets. They do not have the financial or operational structures to do otherwise.
So right now there is no liquidity for credit risk securities. The only way to lay off risk is through credit indices like ABX, CDX, CMBX, which are completely irrationally priced at this point. And as a corollary to the point you note of debt turning to equity - this means that these debts must now be capitalized like equity, in terms of leverage and expected return. Until they can be restructured into debt with highly certain performance, the sources of funds to support them will remain insufficient.
This is not an easy problem to solve, and most proposed ideas seem ridiculous on their face. Market participants are more and more just looking for some sort of deus ex machina to bail them out. And losing sleep over it, even on Saturday nights now.
Posted by: misplaced trust co. at Mar 9, 2008 12:13:50 AM
I'm far from an expert, but it looks like the Fed is taking exactly the wrong approach. If there was a speculative bubble, you'd want to force the market to find appropriate prices rather than keep lowering rates and injecting liquidity to re-inflate the bubble. There's so much productive capacity in the economy that it should be strong if they just let the price-discovery mechanism work for all these assets. As I understand it, what's what Paul Volcker did a quarter century ago.
Posted by: Dan at Mar 9, 2008 12:27:57 AM
Dan is right on -- the fed is majorly screwing the pooch. There was a real mis-pricing of in the markets, based on the incorrect assuption that default risks were much lower than they actually were. The fed cannot paper over that mistake, nor is it the fed's job to find the the correct prices -- only large-scale market experimentation can do that. It is the fed's job to keep inflation under control, and the fed could do it, but it is busy doing exactly the opposite in a doomded-to-failure attempt to paper over a real market correction that must occur. Where is Paul Volcker when we need him?
Posted by: David Wright at Mar 9, 2008 1:41:45 AM
Tyler, come on now, you are supposed to know something about economics.
The economy is about to move up the Laffer Curve(bad)with a tax increase in 2010, and if a Obama or Hillery win, another tax increase in 2009. Thats sorry Fiscal news.
And on the Monetary side Bernanke is presiding over a 8% inflation rate(bad).
Posted by: Russ at Mar 9, 2008 1:48:52 AM
James Heckman's recent paper on high school graduation rates implies something that has gotten papered over -- America's median human capital, which grew tremendously for the first 70 years of the 20th Century, has been stagnating for decades. According to Heckman, the high school dropout rate, for example, hit a low of 20% around 1969, and is now up to about 25%.
We're becoming a less middle class country, but the government lured ever more people into buying their own homes, despite declining average human capital below the upper middle class.
And now there's a reckoning.
Posted by: Steve Sailer at Mar 9, 2008 5:02:24 AM
What is the difference between liquidity and solvency? It seems to me that it is on the scale of 'I cannot pay you today' vs. 'I won't pay you ever'. If I have enough saving - or if somebody else has enough saving, which means low interest rate - I can borrow the money today, pay today and bite the lower profit because of the interest rate. However, if I don't have the resources to pay the interest or if there are no resources to 'provide liquidity', I get insolvent.
The whole problem boils down to the difference between lower/zero profit and bankruptcy - small error or huge error. If the company was able to buy inputs for lower price, it would not need to file for bankruptcy. If somebody devised a technology to cheaply produce, the company wouldn't need to wind up. If somebody had resources to lend...the company would have enough liquidity.... Why did occur to anyone that printing money could solve such problems?
I think it was Hayek who described the result of monetary expansion as undertaking projects for which there is not enough savings to get them completed. Sounds familiar? 'I cannot pay you today, I can pay you tomorrow, when the project is completed'...except that the project cannot be completed, because there are no funds to complete it - because there was miscalculation.
It seems to me that austrian economists were right again.... it might be worth looking on what they say about solving problems the way government and Fed tries it. It might happen that they would be right once again...
Posted by: andy at Mar 9, 2008 6:13:54 AM
tyler, you should reread lombard street.
bagheot's description of banking panics in the 1800's uk looks a lot as to what is happening.
on the other hand, the scale and magnitude now is so much vaster that 1) it is order of magnitudes more scary as hell 2) one wonders is difference of scale translates now into different in kind and all we've learned about credit seizures is not as useful or perhaps even useless.
Posted by: DIS at Mar 9, 2008 7:33:31 AM
Nice to see how many posters believe this situation validates their favorite theory.
Add me to those who believe we have solvency, valuation problem. That does not mean we don't also have a liquidity problem.
Posted by: richard at Mar 9, 2008 7:43:06 AM
Politics and Economics are having a head-on collision RIGHT NOW... keep an eye on Mr. Krugman's articles as you watch the collapse. Will we even make it to an election come November? Keep in mind that George Bush has the power to invoke martial law at any time...
Posted by: Dave Lucas at Mar 9, 2008 8:38:35 AM
I echo the comments of Grant and Dan. I know that Prof. Cowen has pooh-poohed the idea that keeping the fed funds rate at 1% from June 2003 - June 2004 had anything to do with the housing boom, so it's consistent that he thinks central banks around the world injecting hundreds of billions at a time into the credit markets has nothing to do with their gyrations.
The basic problem is that financial institutions are holding assets whose values they are not declaring. I.e. they are afraid to just mark them to true market value, and so investors and other institutions are skittish about dealing with them.
A large part of the blame for this is that the government might announce a new bailout plan next month. Every other day, the op eds in the WSJ has some new plan for how to rescue credit markets with taxpayer/printing press help. Why come clean now and admit your institution lost $xx billion in real estate derivatives?
Posted by: Bob Murphy at Mar 9, 2008 9:39:55 AM
Forget the Chinese, how about, "a fool and his money are soon parted." That pretty much sums up what's happening now. The banks weren't careful about who they lent their money to and now they're broke. Doesn't matter how low the fed sets rates, banks have to stick that money in reserve to cover their prior foolishness.
The markets seem to be working just fine. Everyone expects it will be hard to get credit, the banks will have a hard time, and that people who gave banks money (were buying their weird financial instruments) will go broke. (Of course I live in South Florida and "everyone" here is a little jaded when it comes to banks.)
P. S. Some economists should try reading the Calculated Risk blog sometimes. They would be less suprised.
Posted by: jason at Mar 9, 2008 9:43:31 AM
For what it's worth, the Chinese don't actually say that. There's a nice Wikipedia entry that summarizes this myth: http://en.wikipedia.org/wiki/May_you_live_in_interesting_times
Time to go slowly boil a frog (http://jamesfallows.theatlantic.com/archives/boiledfrog/) ...
Posted by: Kevin Miller at Mar 9, 2008 9:44:16 AM
Check out Karl Denninger at Market Ticker. He's been sounding the alarm since April '07.
http://market-ticker.denninger.net/2008/03/open-letter-to-president-and-others.html
Posted by: Sameer Parekh at Mar 9, 2008 11:49:36 AM
You just have to believe, Tyler.
Posted by: mith at Mar 9, 2008 12:22:32 PM
Can someone who knows more about this explain (or give a link) whether this TAF scheme can actually avoid causing inflation?
Posted by: Sarah at Mar 9, 2008 12:30:16 PM
I think Robert Shiller, in Irrational Exuberance, talked about how "this time it's different" or "it's a new paradigm" is a big warning indicator. It's a red flag. (Or was it Taleb in The Black Swan? Maybe both.)
Debt, risk & etc., had a fair amount of that, with capital inflows from overseas.
I don't think I really understand all that, but if frames what I'm struggling with.
Now consider this:
"Consumer spending accounts for about 70 percent of our economy."
Is there any reason that is sustainable in the long term, other than "this time it's different" or "a new paradigm?"
Maybe it is sustainable and all consumption is ultimately done by "consumers" by definition ... but it seems fragile at the same time, fueled by debt and bubble (at least of late).
Posted by: odograph at Mar 9, 2008 12:46:58 PM
What's wrong with our economy? Well apart from the natural business (and life) cycle of ups and downs, I see our lack of PRODUCTION as a real problem.
We are too dependent on consumption of imported goods and do not produce enough "things" for domestic consumption (and export), which keeps money here in our country. Why is this? Because our elites in DC and New York are not really American patroits anymore, they are true internationalists/globalists, who feel compelled to raise the standard of living of every 3rd worlder around the globe.
We need vast tax cuts for businesses to specifically pursue greater production (engineering, manufacturing, high tech, etc.) within our borders (do we have borders anymore, amigo?)
Posted by: Nessus at Mar 9, 2008 1:12:40 PM
I am no financial guru but the problem looks pretty simple from here. We have the United States Government with far mor power over the economy that is proper. We have one of the two main political Parties deeply involved in messing with that economy. First they force lenders to lend money to those that have a rather poor chance of paying it back because to not lend is redlining and racism.
The same Party then prevents any new energy, causing prices to skyrocket. They then cause the ethanol boondoggle, knowingly putting gazillions of taxpayer dollars into a scheme that uses more energy that it creates while using water we don't have and causing food prices to go through the roof. The same Party then attacks the lenders for wanting to get their money back.
Now, of course, that same Party wants taxes to climb. Only economists and politicians wonder what is wrong with the economy.
Posted by: Peter at Mar 9, 2008 2:01:34 PM
Perhaps Keynes and Milto Friedman are right. The Keynes notion that a liquidity trap can prevent markets from correcting and you need fiscal stimulus to spur such an economy. Never was a fan of the theory before but I didn't go through the great depression. And for those on the other side Milton Friedman might warn of trying to apply economic Darwinism to markets. One of the things that contributed to the great depression, according to Milton Friedman, was just letting banks fail. The resulting bank runs should have been forseen and prevented with minimal initial interventions.
Posted by: DanC at Mar 9, 2008 4:09:24 PM
To Hillary and Obama, what we are seeing in part is how an economy responds to a large tax increase. The run up in oil prices has the same impact as the tax increase they support. And BTW, President Clinton was fortunate to have declining oilprices during his terms.
Posted by: DanC at Mar 9, 2008 4:15:18 PM
DanC, what do you think of this idea that we've done the whole Iraq war on forward borrowing, rather than from current tax receipts?
Posted by: odograph at Mar 9, 2008 5:10:21 PM
Why should I care if it was funded out of future or current income. If the investment is worthwhile how I fund it is less important. If future generations will benefit from the investment, why shouldn't they pay some of the costs. These costs are not hidden from the market and they are priced into current economic data.
I would think the spending on the war is small compared to the tax of higher oil prices or even the direct and indirect costs of ethanol subsidies. But I'm not sure how much military expenditures have increased above where they would be if we were not in Iraq (assuming we would be giving financial support even if we had no troops on the ground). The loss in human life and injuries is very high but the dollars spent for direct military action (after you subtract for rebuilding money to the Iraq government, and normal military spending if these troops were sitting in Germany) is often overstated.
Posted by: DanC at Mar 9, 2008 6:33:19 PM
DanC...the liquidity trap is nonsense. If the interest rate is low, then the lenders will not lend. People will try to avoid holding bonds, they will try to sell them...which causes bond prices to fall and interest rates to rise. What prevents interest rates from rising? Central banks, because of the stupid idea that low interest rates 'stimulate' economy. 'Liquidity trap' is simply a problem that is created by central bank and disappears in the moment when central bank stops 'stimulating'(or destroying?) economy.
Keynes and his followers simply had the stupid idea that 'not enough money' is the cause of our problems. This is a classical 'fallacy of aggregation' - what is true for individual is not necessarily true for a society. If an individual is illiquid, he has a problem of 'not enough money' that can be solved by borrowing from somebody who 'has enough money'. Unfortunately, this doesn't mean that if there is nobody with 'enough money' that the problem can be cost-less solved by printing money. When half of the economy is illiquid, the costs involved with printing money gets so visible, that even the post-Keynessian/monetarist economist at the Fed can see that printing money is NOT a solution to 'not enough money' problem - new money simply translates to inflation and solves absolutely nothing.
Posted by: andy at Mar 9, 2008 7:02:32 PM
