TCS Daily

Student of the Depression

By Desmond Lachman - January 2, 2008 12:00 AM

One has to pity Ben Bernanke as the Federal Reserve faces its worst policy dilemma in many years. Should the Federal Reserve hang tough on interest rates to fend off the past demons of higher inflation at the risk of a deep recession? Or should it cut interest rates aggressively, as suggested by Martin Feldstein and Larry Summers, in order to prevent the economy from sinking into a protracted economic slump at the risk of stoking already high inflation?

By law, the Federal Reserve is charged with the dual mandate of seeking price stability and promoting sustainable economic growth and employment. The Federal Reserve presently interprets price stability as inflation of all items other than food and energy at between 1 and 2 percent. At the same time, the Federal Reserve considers that the US economy has the potential of growing at 2 ½ percent a year without generating inflationary pressures.

With headline inflation now having risen to 4 ¼ percent, or to its highest level in years, the Fed can hardly turn a blind eye to the present inflationary risks. To be sure, it can argue that skyrocketing international oil and food prices are mainly to blame for headline inflation's recent acceleration. It might also argue that, at 2 ΒΌ percent, core inflation, which excludes energy and food prices, is still relatively well behaved. However, the Fed certainly knows that if headline inflation were to remain high for very long, inflationary expectations would be stoked. And were that to occur it would be extremely difficult for the Fed to deliver on its price stability commitment.

Complicating the Fed's decision on interest rates is the fact that the US economy is now being simultaneously buffeted by three major shocks. Home prices are already falling at the national level for the first time since the Great Depression, the financial markets are experiencing their worst credit crunch since the late 1980s, and international oil prices are presently at record levels of over US$90 a barrel. These shocks must certainly heighten the likelihood of a recession in 2008.

The risk of a significant recession is made all the more real by the prospect that home prices will continue to fall in 2008 at an accelerating pace. Already heavily weighing on the housing market is the record inventory of 5 million unsold homes, which are around 2 million more homes on the market than is normal. That inventory could very well be boosted in 2008 by declining demand as Adjustable Rate Mortgages reset at an increased rate, as mortgage lending standards are appreciably tightened, and as speculative positions are unwound. Pricing in that outlook, the futures market in the Shiller-Case housing price index is suggesting that US home prices are likely to fall by between 5-10 percent a year over the next two years.

With the financial system already in turmoil, the US economy could find itself in a downward spiral were it to slip into recession. By further weakening the housing market and by undermining the financial system's collateral, a recession could aggravate today's already troubling credit crunch. And if the credit crunch were to worsen, the recession could deepen as banks became even more reluctant to lend, which would further weaken the housing market.

In a world of uncertainty, a prudent central banker needs to not only balance the risks of alternative scenarios but rather also needs to ask what might be the potential economic and social costs of alternative outcomes. Framing the choice in this way, serious questions must be asked as to whether Mr. Bernanke is being too timid in easing monetary policy to avert the dangers of a deep recession. This would seem to be particularly the case when one considers that the 100 point reduction in the Federal Reserve's federal funds rate to date has been offset by an almost equivalent widening in interest rate spreads in the market.

In present circumstances, it would seem that were the Federal Reserve to err on the side of too easy a monetary policy, core inflation could very well pick up to the 3-4 percent range. While certainly not a welcome development, a problem of that sort could be dealt with over time with a limited cost to the economy. By contrast, were the Fed to err on the side of too tight a monetary policy stance, it would be running the risk of a deep recession that would further undermine the soundness of the US financial system and that would unleash strong deflationary pressures.

As a serious scholar of the Great Depression and the bursting of the Japanese asset bubble in 1989, Mr. Bernanke has to know better than anyone else the costs of having too tight a monetary policy stance as a major housing price and credit market bubble are deflating. This has to give one comfort that the Fed will react aggressively should the present credit crunch get worse and should the economy show clear signs of faltering.



article also depressing.
The author thinks it's bad to have deflation, when that just means that things get cheaper. So it sounds like he'd love the FED to inflate more to avoid it. It's the same old crappy neoKeynsian nonsense. Since the FED was brought into being by stealth, how much has the dollar been inflated? was it 98%, or 90%?

Knock yourself out
How to measure differences in purchasing power of US dollars in different eras:

Isn't deflation is bad too?
Hi Dietmar
Deflation hurts me if I bought a piece of machinery, raw material or equipment expecting to harvest a crop, extract a mineral or build a product and when the time comes to sell it my selling prices is lower than my planned price that made the machinery purchase profitable in the first place.
So I'm out of business due to
I think we can all agree that inflation is also bad or Argentina would other wise rule the world.
My father makes the same claim that the FED was brought into being by stealth (I don't disagree and I certainly have no reason to doubt him I'm just ignorant of the circumstances) and he also wants to go back to a gold standard. Steady money certainly appeals to me because of the problems with inflation and deflation mentioned above so whilst I'm not very happy with the current system Milton Friedman pointed out in his book Capitalism and Freedom(C&F)that paying someone to dig gold out of the ground just to bury it in another hole in the ground(aka Fort Knox) was not a very good use of our resources either. (I am a firm believer in his assertion/agree with him that the FED made the great depression great) I have also read about money shortages in the late 19th century when farmers sold their crops (silver/currency shortages and the like)so some elasticity in the money supply is not necessarily evil.
With that said I believe we should be able to do better than what we currently are doing.
In the book C&F Uncle Milty offered a formulaic (is that a word?) way to increase the money supply at a steady rate hoping to avoid the political pitfalls of our current system but I'm highly skeptical that you could ever take all the political considerations away from a political appointee.
I'd like to be able to print money myself just like the FED and lend it out to banks et al and have them pay me interest.
If I printed too much of my money(Philbacks) then Philbacks would be worthless and I could not earn any interest on my loans if I didn't print enough Philbacks then no one would ever write a contract specifying payment in Philbacks and I would also be out of business.
What do you say Dietmar should we fire up the old laser printer and give the FED some competition?

What the Fed Should Do
"By law, the Federal Reserve is charged with the dual mandate of seeking price stability and promoting sustainable economic growth and employment."

Congress acts as if the FED is some sort of psuedo-deity. They spend without discipline, legislate/regulate without regard to inflationary consequences and fail to exercise their required oversight of the FED...and then expect that whatever happens, the FED can wave some magic wand and all will be well.

The FED has always had relatively limited tools for implementing its Congressional mandate. In the last few years, the FED stronly believed that inflation was an imminent threat, and it raised interest rates at a very rapid rate. Global financial markets, however, beg to differ...the markets do NOT expect inflation...evidenced by the fact that long term interest rates have been fluctuating narrowly around 4.5% since 2002. Raising the overnight rate above long term interest rates, AND not being able to clearly explain the reverse yield curve, was bold and risky...but fraught with unintended and undesireable consequences.

The FED can stabilize financial markets while maintaining a moderate resistance to inflation by gradually reducing the overnight rate to the 3.5-3.75 range by spring.

Some points
1) Yes, deflation is bad as inflation is. What is needed is price stability.

2) Milton Friedman had the gold standard all wrong. A nation does not need gold held in reserve to maintain its currency at a fixed peg to the gold value. It just needs to regulate the supply of its currency to maintain its value as priced in gold. That holds especially true in this day and age with instant and cheap communications and a thriving private gold market. Thus, the government wouldn't have to even get into the business of remitting gold upon demand as people could invest in it like any other commodity like they do now. Remember, individuals in America were BANNED from holding/buying or selling gold during the Bretton Woods gold standard era. A shame really, since Reagan was all set to return us to a gold standard but Milton advised him not to.

3) The banking and monetary crises of the 19th century happened because we did not have centralized banking regulation or even nationally printed money for most of that time. Banks would issue their own script, do so too much and then there were definite problems. The bi-metallic standard was also a flop. There was no central 'bank of last resort'. But in the UK, they had the Bank of England and they didn't have any of those problems. Because of that and the far-reaching effect of the British pound used in world-wide trade, the pound became the world's de facto reserve currency. One just has to look north to Canada's experience at that time, even though it was settling its western frontier just as we were.

Here's a good article on it:

Parts of it are inacurate like here: "Fearing a bank run, the U.S. finally abandoned the gold standard in 1933 but returned to a modified version of it in 1945, when the Bretton Woods international monetary system of fixed exchange rates was established"

We never left the gold standard in 1933, really. FDR devalued the dollar peg from its relation to gold and stopped private holdings/remittances of it, is all.

As for the nonsense about a nation losing its 'flexibility to fight recessions', if some other major nation(s) were to adopt a real gold standard, then all the other currencies would plummet in value against it until policymakers were forced to adopt the gold standard as well. All the 'flexibility' in the world that central banks have with their essentially crappy fiat currencies won't stop that. So, when you hear/read snotty economists who don't know what they are talking about when dissing the gold standard, remember that their 'theories' can't really be tested since no nation is on a gold standard with the fiat ones, can't they?

to pcoiner re deflation
Yes, it hurts you like that and some other people, in the same way on the other side even iflation can help some people. But it's my crappy english didn't describe right. Read Zydrals comments below, which i agree with, and he's the only other guy around here that seems to understand about the gold standard, and has good englisch.

Also right about M. Friedman, he liked free markets but not the gold standard; nobodys perfect. I think Greenspan even said he like the gold standard but of couse he couldn't implement it because he had a cushy job as a functionary in an organ of Big Government.

Z is also right when he said the best thing is stable money. and that can happen with gold backed money, but not fiat currency like the US dollar. The FED floods the world with devalued money and people are mystified by that.
But it's not for us to fire up a laser printer, but in fact there are apparently some private money initiatives with e-gold maybe or Gold-money and some such instruments staring to be used by some busineses.
It's only in the interest of politicians NOT to have stable money.

US deflation vs Japanese deflation
The US will not suffer Japanese-style deflation because the US consumers will continue to purchase stuff they don't need. Even if people know that they can't make their house payments, they will still buy $200 sneakers or a new xbox-360 or $2000 spinners for their pickup. They don't seem to understand the concept of "delay gratification." I know that is true because I see it at the mall where I take my lunch almost every week.

In Japan, the people did not purchase so much stuff. Money was saved for an emergency (rainy day). No matter how the government pushed and pleaded, nobody felt comfortable with spending and buying. Nobody could be prodded into spending when no one felt confident they would have a job or a home the next year.

Also, it was the first time Japanese companies fired people. In the US it was common to fire employees. In Japan, companies always kept their workers in good times and bad. But, that changed. It was another reason to not spend.

So Japan had real price decreases that the US will never see.

The housing prices were too high anyway. Even if they drop 50%, they will still be too high if nobody wants them.

Given the huge national debt
deflation would pretty much sink the ship

re given the/
It wouldn't have to sink a ship. If governments would just stop spending even the debt goes down. And most people continue to keep activities like working, etc. Other countries have also had deflation and didn't sink them. There should be stable money, balanced budgets, but the vested interests, mainly politicians don't want that, so it doesn't happen. They are willing to risk everything, bring about ruination, just to keep in power.

I agree and it is up to us to say as much to our representatives
We are not, as a nation, communicating to our leaders to lower the debt. I think we have been distracted by terrorism and wars.

Moreover, I see very little of this mentioned here at TCS and elsewhere.

Am I missing something here? I may not remember the Great Depression, but I do remember Washington DC shutting down when the government ran out of money (under the 1990 Budget Enforcement Act)

In reading this Wikipedia article, it seems the problem might be that it expired (January?) 2002 but that is was reinstalled in 2007 legislation.

So perhaps there is hope.

Nope, the congressdweebs cheated on that, too
We all saw how this current Congress kept to the discipline of PAYGO when the choices got rough on the patching the Alternative Minimum Tax, didn't we?

According to Wiki, PAYGO was implemented with the Budget Enforcement Act you mentioned. So, I wouldn't hold my breath. They re-enacted it last January as you state but welched on it last month.

Senate votes 88-5 to kill PAYGO:

Now, here's another dirty secret why deficit spending will be with us until eternity: Every dollar bill or Fed Fund in circulation is backed by some type of federal bond or debt (mostly T-Bills). Retire the debt, and the Fed will be forced to either branch out in backing the money with non-Federal debt assets or remove the same value of currency from the money supply. For example, the congresscritters COULD pay off say $1 trillion in federal debt with tax dollars, but the Fed would have to decide what to do about that $1 trillion circulating out there no longer backed by assets.

Recession is a GDP phenomenon...
We are not going to have a Recession...for technical reasons. Nothing within the current economic scenerio will impact the GDP measurements in such a manner that the numbers will drop into the negative range. We hear the word Recession everytime there is any disruption in the financial markets...without any explanation of the underlying mechanisms.

The GDP is calculated as: C+I+G+(X-M)

Consumption+ Investment+ Government+ (Exports-Imports)

C is private consumption in the economy. This includes most personal expenditures of households such as food, rent, medical expenses and so on but does not include new housing.

The purchase of residential housing is not a component of the GDP.

Intuitively, it does seem that excess equity in the hands of consumers and due to the housing bubble, indeed, might have fueled the spending spree that caused those record breaking trade deficits. Insofar as all that is now over, the Gross Domestic Product (the goods actually being produced) in China will take a far larger hit, thereby, than the US economy will.

Similarly, as long as American workers continue to spend basicly all the money they can get their hands on month to month our Consumer spending (component of the GDP) should continue on as long as employment stays high.

Yes, we've been spending too much with credit cards and that foolishness has continued. But if we are going to be forced to slow down some with the abuse of consumer credit now because we are unable to bail ourselves out so easily with a second mortgage...then this would be a good thing, long term...and its impact on the sustainability of our consumer driven economy without disruption (a recession) is positive.

As long as this slowdown in consumer spending is uneven and not abrupt...only its contribution to the rate of GDP expansion is reduced...and the economy will not be dropped into a recession. It does mean that we will stop with some of the stupidity that could lead us into trouble. In that we were moving too fast...we needed to slow down.

Financial market misbehavior...
Recessions always seem to catch us somewhat by the sense that we continue doing obviously stupid things, financially, well past the point that we might have stopped...and brought ourselves under control. Instead we ran on recklessly...straight into the wall.

Another way to say this is that we might better start correcting our individual behaviors...before the market (our collective behavior) corrects itself...and each of us along with it.

Mechanically we should do this by looking to make money by shorting against someone else's unsustainable gains. There are already plenty of us doing precisely that in the modern, global market.

In the current economic environment we've already caught on to many of the opportunities created by the stupidities of some of us. By this I mean that someone, somewhere must be in a position to actually "earn" the money being lost. Otherwise, the exposed value might simply go away.

Foreign banks and Sovereign Wealth Funds are already standing by to step into this arena. Just the past...foreign industrial companies were prepared to take over our production tasks when we were no longer competitive...due to our own arrogance. (Our "schmuck gene" engaged...when we looked into the mirror somewhere in 1980...and said "we cannot be stopped!")

In spite of that our manufacturing companies are fine today. The major dislocation is with the financial entities and their leverage brinksmanship. That was the game du jour this decade and everyone was playing it (or wished they were).

Without enough cash on hand to service their bank lines during the slightest disruption...the SIV's and the hedge funds were going to be forced to liquidate their portfolios if the moment came that they could not roll over their short term bonds. Of course, that moment had to come. Because they continued drawing down all the funds in play...until everyone in the room heard that sucking-sound (as the straw pulled on empty) looked up and immediately put their arms around whatever was on the table in front of them.

Insofar as that underlying collateral in the form of real estate mortgages and those less secure debt instruments (such as credit card accounts) that are, nevertheless, likely to perform...if well managed...still have value, then someone who has the cash on hand can pick up bargains...can quickly be making money on such (by definition) undervalued assets.

Enough of us in the US economy are already participating in the global economy so that losses for some of us here will be made up by gains for others among us...also here.

Americans are only 5% of the global population and our economy is already growing slowly. In fact our economy is so large that it is difficult for it to change very much at all.

However, the global economy is going great guns...growing rapidly...and our companies are leading that process.

Without significant US inflation the value of your dollars in terms of what you use them for here in America has not changed very much. With the strengthening of alternative hard currencies, due to the rapid growth of their underlying economies...if you anticipate buying stuff somewhere outside the USA, then go buy their money. If you need to do that within the current planning horizon at a dollar value that might deteriorate during that future period...then hedge!

In the end, we saw the current risk of recession coming and we have already started correcting our own stupidities. Another way to say this is that we have already "priced that risk into the market".

We're fine for 2008. The US economy will be about flat for 30 more months and start hitting on all cylinders again in the Summer of 2010.

Global Liquidity...
The global economy is creating a great deal of wealth, every day, and those profits cannot be kept around as raw cash. Underlying inflation, however, small, eats away at the value of cash. It must immediately be invested into some liquid asset that covers as much of that inflation as possible or is projected to be likely to.

Insofar as the market stocks of US Treasuries are finite, bidding up those debt instruments only drops their yields at some point (if the buying continues) so that, in spite of their safety...they are not doing the job...they do not cover inflation. In the end, there is only so much liquidity that can be held there...equal to our total outstanding National Debt.

Some of that money goes into the equity (stock) market but, again, there is only so much carrying capacity therein.

Some of that excess money is sitting in FOREX trading accounts...but there is always a significant element of speculation involved in playing with raw currency balances, again. Players must cover inflation and see a clear path to earnings that cover the risks.

The crude oil market has an infinite capacity to hold excess the form of "open interest trades without offsetting transactions" or "contracts never to be fulfilled by delivery".

While the underlying volume of actual crude oil traded has been about flat for quite some time at 85,000 (one-thousand barrel) contract equivalents per day...NYMEX and ICE volumes continue to grow rapidly. To some multiple of the oil flowing itself.

Substantial excess liquidity is being held as crude oil futures. This is fine as long as the value of those contracts continue to move higher. However, when the oil market corrects downward, for technical reasons, as it must, those excess funds must move out of oil and into something else that earns enough to cover inflation plus risk. Insofar as Sovereign Wealth Funds gain traction and are able to generate predictable earnings much of that global liquidity will shift out of its current hiding places (such as oil futures and gold) and into active play.

One of the first targets will be US financial institutions that have misbehaved themselves into so much trouble that their equities are undervalued and vulnerable.

Don't worry about a Recession. Be concerned that you might not have enough business contacts in Asia.

Stable money
Hi Zyndryl & Dietmar
Thanks to you and the others for the great posts
So I think we all agree/it is safe to say that stable money is the ideal so the question is how to accomplish stability.

The gold standard where you don't have to horde large stocks of gold certainly sounds very appealing to me.
Help me understand how this can work in practice.

"It just needs to regulate the supply of its currency to maintain its value as priced in gold."

Are you saying that you that you will peg the price of dollars to set amount of gold.
How can this be accomplished without actually redeeming dollars for gold?
Is the mechainism soley to print fewer dollars if the price of gold goes up and print more dollars if the price of gold goes down?
This seems like it would work instead of redeeming gold you are retiring currency or are printing more currency as needed to stabilize the price.
The money supply could grow as the economy grows but the price could be stable if the FED or treasury was required to maintain the peg to gold?????

"Thus, the government wouldn't have to even get into the business of remitting gold upon demand as people could invest in it like any other commodity like they do now. "

I'm very confused how investing in gold would work with this scenario????
If the dollar value goes down (i.e. price of gold rises) I know the govenment will print fewer dollars (is bound by law in this case) in the future to bring the price of gold down to the peg so I trade my gold for dollars sit back and wait for policy to catch up. I now can purchase more gold with the same number of dollars than before. The trouble with this is that everyone else will know this also so no one will want to trade dollars for gold if they know dollars are bound by law to rise in value against gold.

In the other sceniaro the price of gold goes down so I will want trade my dollars for gold and wait for printing presses to speed up or more money to enter the supply for a while and eventually I would have gold that only cost me a few or fewer dollars or that now is worth more dollars than it was previously or after the FED?? or the treasury?? increased the number of dollars or sped up the printing presses. But who would take the dollars off my hands and give me gold knowing this (a devaluation in dollars) was required by law to happen?

My head is spinning from thinking about it surely there is an easier way to think about it???

Can you elaborate more on the bi metallic currency bank of last resort paragraph?
I'm not sure how this would/could prevent currency shortages????

Thanks again for the great posts

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