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December 2, 2008

the Liquidity trap

Jim Anderson over at SVB published a very insightful piece on the Liquidity trap we are in now (below).  The key take away’s from the Japanese 10 year stagflation and the failure of FDR government led stimulus in the last Depression? 

1.  Higher marginal tax rates make the problem worse and longer (listening Democrats?)

2.  When government expands it “crowds out” private industry taking away the ability of industry to grow, create jobs, recover in any way.  You need private sector demand to drive the recovery.

Don’t let your government do that this time.

Liquidity Trap

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, BofA with the Countrywide deal and even Warren Buffet's latest foray into GE and Goldman Sachs. 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. Households took their money out of the banks and literally buried in the backyard or 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 one percent, the lending rate among banks (LIBOR) until recently was stuck above four percent. Even now with four-week LIBOR down to 1.21 percent, it is 100 bps above Treasuries. 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 allow 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 FDR. The editorial exchanges between Paul Krugman and others found him stretching to defend a political ideology which had little to do with economics. Lest we get to far afield, 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 WWII. 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. 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 were pulled 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 from Ann Arbor to introduce legislation making it more difficult for Toyota, Honda and Nissan to compete? To use a catch phrase 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 and Freddie Mac.

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. If 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 less competent government lender crowding out the more demanding private lender. The disturbing bottom line is we don't really understand in detail 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 percent 30 years ago to over 220 percent today. If that defines the problem then the solution should be a deleveraging over the next thirty years. That deleveraging 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 Fed 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.

Posted by Martin at December 2, 2008 4:48 PM

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