TCS Daily


Two Questions for Mr. Bernanke

By Desmond Lachman - September 18, 2007 12:00 AM

At Tuesday's Federal Open Market Committee meeting, two overarching questions should be put on the table regarding the US economic outlook. Might the credit crunch presently characterizing financial markets prove to be more enduring than previous credit crunches? And might today's credit crunch be being accompanied by special factors that might also weigh heavily on the US economy?

An affirmative answer to both of those questions would be suggestive of the real risk of a prospective marked slowing in US economic activity. It would also be supportive of an immediate 50 basis point cut in the federal funds rate as well as of a clear intimation by the Fed that such an interest rate cut was only the first in a series aimed at supporting the ailing US economy.


Already prior to the August seizing up of financial markets, the US economy was showing signs of slowing, as last month's weak payroll numbers underlined. One now must expect that, going forward, the present credit crunch will weigh heavily on economic growth both by raising borrowing costs and by reducing bank credit availability. In that context, it bears emphasizing that commercial banks will be increasingly reluctant to lend as at least part of the US$1.4 trillion in off-balance sheet activities returns to their balance sheets due to the commercial paper market strike.


Today's credit crunch would not be of much concern if one could be sure that it would be as fleeting as were the 1987 and 1998 credit crunches. However, there are all too many reasons to fear that the present credit crunch will prove to be very much longer lasting than were its predecessors.


Among the more important of those reasons is the high likelihood that it will take time for markets to get clarity as to where the very large losses from sub-prime mortgage lending actually reside, especially given the acute lack of transparency of many sub-prime debt instruments. At the same time, hedge funds must be expected to be sellers of paper as they face increased redemptions for past poor performance, while insurance companies and pension funds must also be expected to offload debt as the rating agencies bend to pressure to bring their AAA ratings for sub-prime debt structures more into line with reality.

Some argue that previous credit crunches had only a limited impact on the US economy and that with hindsight the Federal Reserve over-reacted to those earlier episodes by excessively cutting interest rates. However, in today's context, that line of reasoning overlooks the fact that the present credit crunch is occurring at the same time that major asset price bubbles in the US housing and credit markets are in the process of bursting. It also overlooks the very much more leveraged state of financial institutions than before, which now poses a threat to the real economy as that leverage is unwound.

In assessing how the very changed circumstances of today's credit crunch might negatively impact the economic outlook, the Federal Reserve would do well to pay special attention to the fact that US home prices are now declining at the national level following their spectacular 80 percent run-up between 2000 and 2006. Worse still, there is every prospect that home prices will now start falling at an accelerating rate through 2008. They will do so as a very large volume of adjustable rate mortgages reset at higher rates, as mortgage lending standards are tightened, and as a rapidly growing number of foreclosed properties return to an already very saturated housing market.

Declining home prices must be expected to worsen the present credit crunch by increasing the losses on sub-prime mortgage lending. Indeed, with falling home prices, such losses could easily be more of the order of US$200 billion rather than Mr. Bernanke's US$100 billion loss estimate. More serious yet, as Marty Feldstein correctly noted at Jackson Hole last week, declining home prices could constitute a major drag on US consumer spending both by reducing household wealth as well as by further constraining households' ability to engage in mortgage equity withdrawal.

Mr. Bernanke has earned a well-deserved reputation as a serious scholar of Japan's Great Deflation of the 1990s. One can only hope that Japan's earlier experience now sensitizes him to the very real risks to the US economy that would flow from an inadequate Federal Reserve response to the combined shock of a serious credit crunch and the bursting of a major asset bubble.


Categories:

5 Comments

Lets heal a broken leg by breaking a finger.
The FED actions are about the same as recommending that patient heal their broken leg by breaking a finger. That is simply it will only make matters worse to increase the money supply as that is what got us into this mess in the first place.

Oh, but this time it will be different. The Fed is smarter and has more computers. Of course the economy is much more complex but that has nothing to do with it.

We should get rid of this last stronghold of central planning and go back to a stable money supply working towards a more stable standard like gold or silver.

These Fed actions will move money from cash rich investors to these sub-prime and other bad debt holders. Thus freezing these mis-investments up from the rest of the economy getting to use them.

Also, why is it bad that prices retreat from the 80% run up? Maybe the 80% run up was false emotion driven panice because of loose monetary policy and needs corrected?

They can do it...just not sure if they won't screw it up
They can take as much base money out of circulation at the same time they ease up on the fed funds rate. They just need to sell the bonds they are sitting on while taking the money from the proceeds out of circulation (destroy it).

Also, the fed funds rate is the rate they charge for temporary, short-term loans as a last resort to banks. The repaid loan money is taken out of circulation just as in the proceeding paragraph. So the banks just borrow more. That's ok, that's what being the lender of last resort is all about and the main reason why we have central banks, really.

But the problem with engaging in deflationary policies is that asset & commodity prices fall during deflation (just as they rise during inflation). Home prices will thus fall even further.

Dealing with collateral damage should not be the Fed's responsibility but the reality of the situation is that the entire Board would be sacked by a special legislation of Congress if they didn't worry about it. And they know it, too.

So, inflation will be the order of the day -- unless/until it gets real bad. The price of gold in dollar terms is a very accurate indicator of future inflation and it has spiked since 2003. Inflation makes debtors able to pay off their mortgages in devalued bucks..we are heading into a major election cycle...so, guess which way the political wind will blow on this one.

We're all about to find out what stones - if any - that Bernanke & Company has. Ditto regarding the gray matter mass in their skulls. I personally do not have high expectations.

Just be happy about the competition for world's reserve currency that the euro provides. It will constrain the Fed from doing something really stupid and/or force them to quickly correct such stupidity should they fail.

Living beyond our means
We have been living beyond our means for decades and it is catching up. Coupled with excessive Federal spending and Iraq were deflating our currency.

The real scary part is most of the candidates for President, especially on the Democrat side only advocate more spending and higher taxes, neither of which will grow the economy or decrease deflation of the dollar.

I am afraid were in for a tough road and the real scary part is unlike recessions of past, we might endure this one all alone as the Euro becomes the reserve currency of choice dollars will be dumped and this will insulate other economies from our demise. A dumping of dollars would be a disaster.

The stupidy of our politicians is astounding. All side, both parties are killing us off.

Now Bush climbs on the Health Care bandwagon. Yet another plan to suck the coffers dry and empower the state.

When we will vote the bastards out?

beyone the frindge
But it's in the interest of all political parties to print fiat money, when the pidgeons come to roost at home, those slim bags will be already retired with their cushy pensions and other money ripped off from the people. What do they care? And people won't vote for real alternatives, not even like Ron Paul, or Harry Browne, because most are afraid of freedom, after being brainwashed and coddled all those decades.

bastards out, bastards in
True dat dbt, we can vote them out, but they just get replaced with more. They're all the frickin same. We need to get back to the American way. Its not left vs. right, R vs. D, its US against THEM, The People vs. Big Brother. The People are just too damn stupid and comfortable to do anything. And the parties have successfully divided us for their own benefit.

We need less spending and higher taxes to get us back on the right course. Thats where Reagan had it right, he restored his tax cuts when conditions warranted.

I have an idea, how about we make a law that every person who voted for Bush in 2004 has to pay $100 a month to pay for the occupation of Iraq as long as we're in there. It would appropriately penalize those responsible and provide funding to help save our economy too.
Not that Democrats are better about spending, they're worse than average, but no worse than Bush on spending. And at least they would do more to fund our bloated spending rather than drown us and future generations in debt.

And one more thing, how can someone write a current article about our economy and "Two Questions for Mr Bernanke" and not discuss inflation?? Everything else going bad is secondary to the threat of inflation in our economy. And the Fed lowers rates! Great, lets bail out the shady mortgage companies AND weaken the dollar. 2 for 1. I'm sickened by this madness.

But hey, I got an ARM coming due in about 9 months, at least I'll benefit in one way. A**holes.

I don't care about experience or talent or charisma or strength or whatever traditional factors we all use to decide who to vote for President. I want someone who will ROCK THE BOAT. 1. Publicly financed political campaigns.

TCS Daily Archives