Tuesday, February 17, 2009

We're All Keynesians Again

"We're all Keynesians now," quipped Richard Nixon in 1971. And so we are once again.

Let's first highlight a few of the more noted Keynesian concepts working through today's headlines.
  • Animal Spirits: the confidence level of market participants, and their willingness to commit risk capital
  • Countercyclical Policy: government intervention that slows down or stimulates an economy
  • Liquidity Trap: the situation in which monetary policy is no longer effective
  • Multiplier Effect: how much government spending increases national income
  • Paradox of Thrift: slowing economic growth that comes from consumers saving too much and not spending
The thing about mixing politics and economic theory is that purists never get their way. Whether you're a monetarist or a Keynesian (or anyone else), the political result is normally a disappointing compromise. It can never fully eliminate a rival school of thought, which always guarantees continuing debate.

No doubt, policymakers do favor certain theories, especially during periods of inflection when "getting it right" means an extended pass on political livelihood.

With today's signing of the fiscal stimulus bill, the shift to Keynesian theory is complete (though not absolute), having begun during the Bush administration.

If, however, the economic result does not meet the electorate's expectations, expect immediate, widespread political upheaval. For example, countercylical policy fails or only partly resolves the paradox of thrift; the multiplier effect does not ignite animal spirits; and from the liquidity traps springs forth inflation or, worse, stagflation.

Over the coming months, look for policymakers to manage these expectations, perhaps even advocating a more absolute approach.

The question is, Does the electorate have the income and net worth to stomach the rhetoric?

Sunday, February 15, 2009

Deflation Scare

Last September fear gripped the financial markets like few times before. By the 20th, Fannie Mae, Freddie Mac and AIG had been nationalized, Lehman was bankrupt, and the buck was broken. The financial system came within a whisker of shutting down completely.

Though we still face hard times ahead, we've backed away considerably from last autumn's precipice, thanks primarily to Mr. Bernanke's handy printing press. Nevertheless, there's an important illustration of deflation here, and its connection with the financial system.

The chart below expresses this relationship as contrasting lines between implied inflation and expected share price volatility.


  • The TIPS spread (left-hand scale) marks the difference between the 10-year inflation-indexed Treasury and the conventional note. A deflationary spiral began immediately in September, and continued through December.
  • The VIX index (right-hand scale) measures expected annualized change in the S&P 500. At its worst, the VIX anticipated an 80% move in the S&P 500. Over the past ten years, this has averaged 15%. The level has since "improved" to 44%.
  • Correlation between the two lines is -83%, indicating just how much markets fear deflation, and don't mind mild, predictable price increases.

A small degree of inflation is actually positive. It shows there's pricing power and that the economy is growing. And just as a sudden acceleration distorts economic balance, so does a sudden reversal. In deflation, not only does income fall, but the value of fixed costs rises. People have less money to pay mortgages, rent, utilities, tuition and health care. If leverage ratios are high, net worth deteriorates rapidly.

In an inflationary scenario, the Fed in theory can raise benchmark rates indefinitely. With deflation, it can only reduce these rates to zero, which in today's environment means no latitude other than creative balance sheet expansion (itself a significant inflation risk)

Though down substantially, deflation risk persists, especially as policymakers now set their sights on remaking the banking system.

Thursday, February 12, 2009

Asymmetric Information

Sandy Weill built Citigroup into a colossus just before broadband Internet took effect.

Over the next decade, shareholders supported his aspirations with an average market value of more than $180 billion. Today, Citigroup is worth less than $20 billion.



Up until 2000, information control resided firmly on the sell-side (the market-making side of Wall Street). Broadband Internet changed all of this, by shifting the advantage to the buy-side.

At the same time, socioeconomic upheaval in emerging economies recast global capital markets. Eye-popping returns across asset classes immediately followed. Injected with subprime fuel, Citigroup and other sell-side firms revved up proprietary trading vehicles, and chased information advantage.

Meanwhile, financial leaders such as Mr. Weill simply continued targeting market share gains based on pre-Internet rules of engagement.

Nearly ten years on, Citigroup and the old model have crashed and burned.

The political conversation finally recognizes that many institutions are no longer viable. This is good news – so long as the resolution does not hold back on allowing market dynamics to determine winners and losers.

Government predetermination, on the other hand, would be no different than Mr. Weill's empire building – ignorant as it was of fundamental, market-oriented change.

Information asymmetry would soon reemerge, and incinerate us once again.

Tuesday, February 10, 2009

Slouching Towards Socialism

Hurricane winds are about to blow us off a cliff, if we're not airborne already.

Or so we’re told.

The headline numbers look pretty glum indeed:
  • 3.6 million jobs lost since the recession began, including the largest 12-month decline ever
  • 7.6% unemployment – 13.9% if you add in all the folks forced into part-time work
  • 3.8% annualized decline in GDP, and going down
Wall Street banks, moreover, are seemingly squandering taxpayer money on boondoggles and bonuses, without any consideration to increased lending. The storm is so big, in fact, that only government can steer us through it.

And so it will.

But are we really in free-fall? The following two charts suggest otherwise in two of the biggest problem areas: housing and credit markets.

This first one – housing affordability – measures whether a typical family can qualify for a mortgage on a typical home. 100 means the family has exactly enough money.



As of December, a family now earning the median income has 159% of the income necessary to qualify for a conventional loan covering 80 percent of a median-priced existing home. Of course, this does not reflect confidence on either the mortgage lender's part or the borrower's, but at least a transaction is doable.

This next one shows the TED spread, the difference between of the three-month interbank lending rate and the US Treasury. The spread reflects counterparty risk, which some see as the central complication behind the credit crisis.



Though still more than twice pre-2007 levels, it too has significantly improved since the height of the shock.

Newsweek magazine says we're all socialists now.

Well, maybe not quite yet.

Friday, February 6, 2009

Turning from Deflation to Inflation

Economic events can happen abruptly. So what's the next big shock? A sudden return to normalcy – or something else?

Let's consider three basic facts that are likely to persist throughout this next cycle:
  • a risk-averse market psyche
  • government distrust of capital markets
  • a recast global playing field
Deflation's painful squeeze will keep consumers from spending anything close to prior cycle levels, especially as they unload a worsening debt burden. Similarly, businesses will scale back investment projects, depending on degrees of leverage. And despite federal transfers, state and local governments won't fully reload until tax bases do so first.

Whether it's gun-shy lenders or battered borrowers, the market is now profoundly risk-averse, and even in full recovery we won't likely see the prior cycle's mania for some time. And while this might be a good thing, it means we'll have to contend with structurally higher capital costs.

Also, global credit flows are likely to display different patterns. As the US government takes on more debt and its deficit expands, it will become even more dependent on financing from large surplus countries such as China and Japan. If, however, these countries' own economic expansions fall short and other trading partners can't compensate, then the Fed will need to make up the difference – that is, if the Treasury can't close the gap with higher tax receipts.

Take all of this against a government-controlled financial system, and today's top-down solutions could force not just a more volatile economy, but also unchecked inflation.