November has been a cruel month for the markets as well, especially the last couple days. Some days I turn on CNBC and literally see things that I never thought I'd see. Watching the 30 year Treasury yield take a dive like it did yesterday would be one of those things. Seeing Citi at less than $4 would be another. Hearing perfectly reasonable people fret about the possibility of deflation would be still another.
How do you title a blog post these days without sounding like a doom-and-gloomer? I feel like I want to choose my words very carefully to avoid making things seem worse than they are. (I know how you feel, King!) But when you hear speculations of a pretty sizeable drop in GDP in the 4th quarter and graphs showing this to be the worst stock market decline since the Great Depression, it's easy to get caught up in it.
So as I work my way back into the swing of things over this Thanksgiving break, let's just set the stage.
The auto bailout: Not a good idea, but probably going to happen in some way, shape, or form. At the rate that they're burning cash, I don't see what a bailout would reasonably hope to accomplish. A fast track to a government assisted bankruptcy would probably be better in the long run. I would support proposals to protect the pensions of workers, especially those near retirement because that represents a past promise that people took into account when making decisions. That's probably a good topic for a future post. But this decline has been a long time coming, and trying to stop it is just going to add to the problems later.
Paulson's reversal: I, for one, found that episode at least somewhat refreshing. Some say that he realized that $700 billion would not be nearly enough. Perhaps. But if that's the case, I'd rather he stopped at the brink of the canyon like he did rather than jumping in and then telling us. Yes, we could use some more transparency in seeing where the money has gone so far. But most importantly, the fact that they're holding back some of that money means that at least one agency is doing something to keep its powder dry. Which brings us to...
What will the Fed do in December? That's what my macro classes are working on figuring out. After Thanksgiving, I'll be discussing Poole's 1970 QJE paper with my grad students. I guess that will be as good a time as any to bring up this development: (Bloomberg)
``There has been a policy shift, but the Fed is not transparently announcing what it is doing and why,'' said former St. Louis Fed President William Poole, now a senior fellow at Cato. ``Monetary policy works best when the markets understand what the central bank is doing.''
Some analysts point to the surplus cash that banks keep on deposit at the Fed as a key gauge of the Fed's monetary-policy stance. The so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed added to its emergency lending programs.
``It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset,'' said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.
Hat tip to Calculated Risk.
Indeed, when you see things like this, it makes you wonder what is going on. I'm going to be thinking about that a lot this week during the break from classes.
So what about deflation? I'm not in the camp that thinks it's a big problem yet. It becomes a real problem if wage declines make it even more difficult for people to make their mortgage payments or if price declines are so widespread and expected that people hold off spending now as they expect prices to go down further. I don't see us getting there yet, but I stand ready to revise my expectations as new data arrives.
And finally stock market: I'm just as caught up in it as you are. My explanations are no better than anyone else's. It does appear that we're on the verge of something with Citi, and people are getting worried about commercial real estate. Those make for some strong headwinds.
As I go around town I hear comments both positive and negative. Everyone complains about their 401(k)s, but local businesses are hiring. I do think that we're in a recession as we would define one nationally. However, the impact is going to be very different for various regions and economic sectors. It's difficult to fight recessions like this because it becomes more tempting to try to target policies at one area or another, and that's not always good or successful.
But it does give us things to talk about.
Lots to talk about indeed! I'm sure the textbook manufacturers are quite pleased. I would very much like to hear the Fed simulation in your class at the end of the semester this year. I remember for mine it was during a rather boring and predictable period. I'll be very interested in the results of this one.
I hate to say it Dr. Polley, but I was the first to use the D word (deflation) in your class, after you showed us the latest fed press release in class.
If you look at the FOMC minutes you'll see they mention the D word also in this paragraph long sentence:
However, others maintained that the possibility of reduced policy effectiveness and the limited scope for reducing the target further were reasons for a more aggressive policy adjustment; an easing of policy should contribute to a beneficial reduction in some borrowing costs, even if a given rate reduction currently would elicit a smaller effect than in more typical circumstances, and more aggressive easing should reduce the odds of a deflationary outcome.
At about the same time the NY Fed (my assignment in your Fed project) published a research paper entitled "Imperfectly Credible Disinflation under Endogenous Time-Dependent Pricing." This model highlighted the importance of credible policy makers as well as the learning period of players in the market.
Deflation seemed inevitable because of the neutrality property of money as well as new downward pressures on profits. Without banks making loans, the money multiplier stops. Without consumer spending, velocity of money slows.
Market expectations are constraining effectiveness monetary policy. The problem isn't interest rates are too high or low. The problem is investors don't know what to expect, and are putting their money only in the safest places avoiding as much risk as possible, this collective selling action is responsible for the crashing markets we're seeing. Fed watchers are thinking the fed is out of ammo, if deflation takes hold, the Fed will be powerless.
Households and firms use historical data to make their expectations, but as you comment on your blog, you're seeing things that you'd thought you'd never see, and are highly uncertain what will happen next. It is times like these that global policy coordination is necessary. The G20 could agree to fix their interest rates in unison, and pledge to keep them within narrow bounds for half a year or a year, for example. This will give households and firms one less changing variable to factor in their economic forecasts, which will help promote market stability.
Currency manipulation from speculators should also be made illegal. To explain why would take a long time, but it will lead to more stable currencies, which among other things will lead to more accurate economic expectations. I'm still looking into the pros/cons of allowing treasuries to be sold to foreigners.
Increased fiscal spending is required, nothing drives me more crazy then having nice factories and skilled workers unable to do what they're good at because of a financial meltdown. A tax cut large enough to give consumers enough money to resume their spending habits they were accustomed to during a growing economy won't do the trick, in the same way that the bailout plan didn't achieve its goals. Consumer's are still too frightened to spend and invest. Instead giant public works projects can provide jobs to create an employment buffer while market players learn how to make rational expectations in the new framework.
Lastly, the main thing that must be done is governments world wide need to create new regulation that will restore confidence in the markets. This is what the federal government did when they made banking boring by passing the Glass-Steagall Act. Everyone is holding their breath waiting to see what the Glass-Steagall act will be of our day. It needs to address all the conflicts of interest that created this world wide crash but not suffocate innovation. It needs to be implemented world wide, so that the speculative money won't go somewhere where regulation is looser, and money can be made from more bubbles.
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