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The liquidity trap
Commentary: Financial engineering seems worse than the alternative
By Jim Anderson
Last update: 12:01 a.m. EST Dec. 5, 2008Comments: 157SAN FRANCISCO (MarketWatch) --

This year one of the best performing asset classes is cash.

People used to boast about hot stocks they owned. Now they crow about how much of their money is in cash. Those holding cash have been richly rewarded with no losses and opportunities to buy assets (condos and equities) at huge discounts.
As prices continue to decline, those that moved too quickly to buy at the bottom are seen as fools. Consider the massive losses of the sovereign wealth funds, Bank of America
BAC 14.49, +0.15, +1.1%) and Countrywide, and even Warren Buffett's latest foray into General Electric (GS 66.21, -1.32, -1.9%) . Investors, convinced that prices will continue to decline, sit with their liquid resources on the sidelines. As that investment demand takes a holiday, prices will decline further.
This phenomenon is well understood. In the 1930s, it was called the liquidity trap. People took their money out of the bank and literally buried in the backyard or stuck it under a mattress. When that happened, the money supply contracted another notch and the lack of transactions cut into the velocity of money.
As the supply of money and bank reserves dried up, credit availability declined and asset prices fell yet again. Today, because of FDIC insurance it is not the households that lack trust in the banking system but, rather, the bankers themselves.
Even with fed funds at 1%, the lending rate among banks (LIBOR) until recently was stuck above 4%. Even now with four week LIBOR down to 1.21% it is 100 basis points above Treasurys.
Incredibly, the four-week bill is yielding one lonely basis point. We saw the same effect in Japan in the 1990s, when their banks were clogged with bad loans and were unwilling to lend despite funding costs at zero-percent. The largest banks instituted strategies to refuse additional institutional deposits because they had no loans they wanted to make. It took more than a decade for a modicum of liquidity and transactional velocity to return to the Japanese economy.
We can hope that our leaders today would benefit from the experience of the 1930s. Some of the mistakes made during that era have been carefully chronicled as extending and deepening the crisis. Chief among them were higher marginal tax rates, increases in import tariffs and a lack of international coordination producing round after round of competitive currency devaluations.
Unfortunately, the history is still too fresh to have a completely rational perspective and the debate now raging among economists is being filtered through a political lens that has as its focal point the historical standing of Franklin D. Roosevelt. The editorial exchanges between Paul Krugman and others found him stretching to defend a political ideology which had little to do with economics.
Before we get to far a field, the data show that the Depression as measured by economic activity and unemployment got slightly better, then worse, then stabilized at a very low level compared to the 1920s. The one thing perhaps all can agree on is that the true end of the Great Depression did not occur until after the start of World War II.
Employing millions of men in the activity of destroying most of the economically productive assets on the planet was, after all, an obvious solution. At once demand was created with all those new jobs and supply was severely constricted. Naturally prices began to rise (rapidly after the war) and the deflationary spiral was broken.
To be sure, global conflagration is not a policy direction anyone would endorse no matter what the effectiveness.
Learning from the New Deal
So why didn't the New Deal produce the desired results? One concept now gaining a following is the crowding out effect of government intervention in large areas of economic activity. As new projects were created under government control, the productive assets got sucked out of private hands. The government could pay higher wages and command lower materials costs essentially pushing any hope of private sector competition aside. To enhance their commanding position, laws were passed to favor the government entities over private business.
As an example, suppose the Big Three of Detroit are nationalized. How long would it take some enterprising congressman to introduce legislation making it more difficult for Toyota TM 56.21, -2.19, -3.7%) , Honda HMC 17.52, -0.67, -3.7%) and Nissan (NSANY:nissan motors NSANY 6.32, +0.09, +1.4%) to compete? To use a catchphrase we hear all too frequently these days, they would do it to "protect the taxpayers' interests."
Soon cars would be more expensive and quality would decline. Jobs would vanish as foreign manufacturers moved to other more friendly markets. Finally, the shrinking private sector would be unable to cope with the ever increasing tax burden needed to pay for the expenditures required by more government intervention. If you want a small example of what happened in the New Deal consider the recent distortions in our mortgage market delivered by Fannie Mae FNM 0.83, -0.04, -4.6%) and Freddie Mac (FRE:Freddie Mac
FRE 0.84, -0.04, -4.7%) .
The bigger worry is the case of Japan, where for more than a decade they followed every policy prescription western economists could devise. The failure of these measures is often attributed to their lack of intestinal fortitude in dealing with a banking sector awash in bad loans. Pretending bad loans were solid did not increase trust in the banks or increase their propensity to lend. Now, we also are hearing policy ideas intended to "keep people in their homes".
A bad mortgage loan will not become a good loan even with some government edict. In fact, the edict will ruin the market's ability to make loans to creditworthy borrowers because they will never know when the government will allow them to enforce their legal rights to the collateral. A sort of Gresham's law of lending will ensue with the bad quality lender crowding out the good quality private lender. The disturbing bottom line is we don't really understanding what happened in Japan.
There appears to be a consensus that the economy was over-levered from households to corporations to government-sponsored entities. Leverage as measured by total debt to GDP grew from 140% 30 years ago to over 220% today. If that defines the problem then the solution should be a de-leveraging over the next thirty years. That de-leveraging will cause prices to fall dramatically as the credit supply shrinks, money supply falls and velocity slows.
The policy agenda currently in vogue is to maintain the leverage and the asset prices by shifting all that debt from the private sector to the public. Why are we doing this? Because the near-term political heat from a deep recession and re-pricing of assets is more than any of our leaders can handle. Eventually that massive intervention and concomitant increase in the money supply will come with a hefty price tag.
Anna Swartz, co-author with Milton Friedman of "A Monetary History of the United States," addressed that question in a recent Barron's interview. She speculated that the deflationary impact of collapsing credit will be offset by the inflationary momentum of liquidity currently flooding in from the Federal Reserve and the Treasury. Pulling off that balancing act would be the central banking tour de force of the modern era.
We wonder if working that delicate arrangement isn't perhaps riskier than simply allowing the short and harsh brutality of the market to work its wonders of creative destruction.

Jim Anderson is president of SVB Analytics, a firm providing solutions to analytical and valuation problems specific to technology, life science and venture capital companies.
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Unfortunately the guy who wrote this was bean counting while Rome burned.
We were facing a massive financial crash with NO credit available. Thanks to the government intervention there's plenty of credit as long as you are stable and able to pay the bills.

For the companies going to Congress hat in hand this isn't the case and for GM and Chrysler its doubtful they can be saved regardless of government inervention. Ford is in much better shape, only asking for provisional credit guarantees that they probably wont need. Likely any further govy. action in shoring up industries, mortgages and public works will be simply a waste of money, as in the New Deal. But as in the New Deal instead of waiting it out the voters want action, no matter how useless or counterproductive.

Great Depression causes: "Chief among them were higher marginal tax rates, increases in import tariffs and a lack of international coordination producing round after round of competitive currency devaluations"

Hoover and FDR put in huge, grotesque marginal rate increases, and up until FDRs bank holiday the US banking system was allowed to collapse like a row of dominos, only slightly slowed by Hoovers efforts. As a result interest may have been kept low by Fed action and deflation but credit was VERY tight and that and the lack of private capital investment becaue of the high taxes is what delayed the recovery so long and caused the 1937 Recession.

Meanwhile EVERYONE has their hand out for goobermunt money as usual - not just car makers and banks:

MALKIN: No newspaper bailouts
Michelle Malkin Washington Times
Saturday, December 6, 2008

It was supposed to be a joke. As an endless parade of corporate beggars marches to Washington in search of handouts for their beleaguered industries, some of us in the news business snarked that journalists would be next in line. I launched a Newspaper Bailout Countdown Clock on my blog after the New York Times Company's bonds plunged into junk territory in October. A few weeks later, columnist Jon Fine published a tongue-in-cheek memo in BusinessWeek outlining a federal newspaper rescue proposal.

The jibes were meant to be facetious critiques of for-profit enterprises demanding massive taxpayer expenditures under the guise of preserving the "public interest." But now, in a rather unfunny turn, the newspaper bailout push has actually come to pass.

The Republican governor and the Democratic attorney general of Connecticut went on the record last week in support of government intervention for failing local newspapers. God save us from bipartisanship. Their joint statements pushing a salvage program came in response to news that The New Britain Herald, The Bristol Press and 11 weekly papers across the state face closure. About 100 jobs are at stake. This is bad news, no question. But cause for apocalyptic talk and expansive meddling by politicians? Please.

"This is the worst financial turmoil I have ever seen, not only in our state but in our nation," Gov. M. Jodi Rell lamented as she expressed her support for some sort of government/media salvation plan. Attorney General Richard Blumenthal asserted: "The newspaper is an information lifeline. It provides really an essential service." Among the "essential services" Mr. Blumenthal thinks taxpayers should prop up: marriage notices and school sports announcements.

These items are easily and effectively disseminated online. Connecticut consumers who are passing up the newspapers that offer these products obviously don't agree with Mr. Blumenthal that it's "essential" to get them in dead-tree form. But Ms. Rell seems to believe quaintness is an argument for government funding: "There's something about having that paper and being able to sit there with your cup of coffee or your tea and read through and find out not only the news but the real feel for a community."

Local lemonade stands give you a "real feel for a community," too. Should Johnny and Susie get handouts for keeping it real? Should we resurrect Woolworth's with some of Treasury Secretary Hank Paulson's bottomless bailout billions while we're at it? Why not bring back town criers with public subsidies, as well?

Unperturbed, seven Democratic state legislators stepped up further pressure by sending a letter to Connecticut's Department of Economic and Community Development seeking help for the dying newspapers. With straight faces, they wrote: "As elected officials, ourselves, we want [the] public to have access to independent news about what is going on in government and our communities. We share the sentiments of our nation's leaders who wrote the Bill of Rights that a free press is an essential part of democracy."

How "free" can a "free press" be if it is leveraged with government funding? How free would they be to criticize other corporate enterprises seeking local, state or federal help to keep them afloat in hard times? Quis custodiet ipsos custodes? A press beholden to the ruling class - a press that cannot stand on its own two feet and the strength of its product - is a press better off dead.

Michelle Malkin is a nationally syndicated columnist and author of "Unhinged: Exposing Liberals Gone Wild."
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