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19.03.2008
Ben's depressionThe pattern is always the same. When the Fed cuts interest rates, investors pile into the markets, pushing up share prices for a few hours. It takes then only a few hours until some other scare story comes up, and the whole process goes into reverse. US shares shot up following the Fed's announcement. This was followed by a mini-rally in Asia, but back in Europe, we are down again on rumours that Royal Bank of Scotland may be in trouble. That rumours is almost certainly false, or at best self-fulfilling. If HBOS was not in trouble, it may be now. In any case, monetary policy has no noticeable effects on equity markets. Their dynamics is driven by fear.
A monetary policy geared towards stabilising equity markets, which appears to be what the Fed is doing, is ultimately futile. Stock prices are discounted values of future earnings, and the decline in the market reflects two related issues - the rise in the probability of huge tail risk in the form an escalating financial crisis is and the expectation of a deep recession. Unless the Fed's policy action can convince market participants that low interest rates will alleviate one or both problems, a rate cut is not going to do anything. And if the Fed cuts too much and produces inflation, long-term interest are certain to rise. This would increase the tail risk of a systemic collapse of the financial system and prolong the recession. In other words, if you cut interest rate too much, stock prices may actually fall. In other words: Interest rate cuts could cut both ways.
The correct policy response would be a combination of generous liquidity provision (though no bailout of prime brokers), nominal interest rates set at a level that is commensurate with price stability (about 4-5% in the US, not 2.25%), and punitive bailouts of ailing financial institutions. Those fiscal bailouts need to be structured in such a way that the public maximises its long-term risk-weighted returns at the expense of financial industry shareholders and stakeholders. In other words: if we bail out bank X for $10bn, then we do in such a way, that the bank's shareholders and employees will transfer back to the public the financial aid granted plus interest at some punitive rate over a number of years. Parts of the financial system would be forcibly nationalised, and re-privatised at a profit later. It would also be right to impose a special tax on financial institutions and their employees in the form of punitive taxes on wages, and earnings.
The wrong policy response is trying to avoid a recession at all costs. This is not only because it delays the day of reckoning, as it is so often put. The real problem is that such a policy might unleash a catastrophic dynamism. The Great Depression of the 1930 ended swiftly once monetary policy started to target price stability again. In our case, it will be the other way round. Once the Fed is forced back on a path of targeting price stability, our Great Depression will begin. The recession could turn into a depression precisely because monetary policy set out to avoid the recession in the first place.
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Comments
John from US
Monday, 21-04-08 05:01
When you talk about the coming Depression, what type of depression? Do you mean the deflation kind of depression? If you mean that, I think you are wrong. Most financial commentators focuses on Ben Bernanke and the Fed. The Fed alone does not have the power to fight deflation. They will enlist the help of the US government. When you put the two together, the end result is hyperinflation.
Still not convinced? Take a read at http://cij.inspiriting.com/?p=337 That article explains it far better.
Wiley Horne from USA
Tuesday, 25-03-08 23:21
The only flaw in Wolfgang's argument is this: The politicians of the United States will never accept a depression. Indeed, they will not even accept a corrective recession. They have and will always opt for inflation. To fend off recession, Congress will fight the fiscal fight (pork-barrelling and grandstanding comes natural to them) and the Fed will use it's helicopter tactic of printing more money to drop on the problem du jour. I wish we could trade the whole lot of them for the fiscal conservatism of Germany's elected officials and Bundesbank--but perhaps in a democracy you get what you deserve.
My advice: Bet on inflation in the US. Always inflation. I am using an inclusive definition of assets and true consumer prices, and am paying no attention to the falsifications printed as 'headline inflation'.
The US citizen is frequently demeaned as an improvident non-saver, but what we are seeing there is simply learning behavior. The lesson has been taught, and the lesson has been learned, that our elected officials and Fed governors (since the legendary Paul Volcker) have no qualms about turning our currency into trash. Best thing to do is get leveraged. I am a disgruntled bond owner, myself. Can't get over the saving habit.
FH from CH
Wednesday, 19-03-08 15:37
It was HBOS (Halifax Bank Of Scotland) that was rumoured yesterday to be in trouble. The other big bank in Scotland is RBS (Royal Bank of Scotland). As a result of Herr M.'s little error (ein Tippfehler?), the RBS may tomorrow be rumoured to be in trouble too (and wondering why).... Kleiner Fehler, grosse Wirkung....
As to a depression in the USA, Americans may have to brace themselves and adjust to a lower standard of living for years to come, since it will be extremely difficult to sell US debt in Europe and in other parts of the world. But banks will move on to fresh pastures - in the Orient where growth is unstoppable. Deutsche Bank, for example, is greatly increasing its already huge amount of office space in Singapore.
Interestingly, one hears/reads every day in the German-language media about German firms rapidly increasing their presence in the BRIC regions. But they are also expanding manufacturing operations in the USA to counteract the effects of the weak dollar on German exports. This means , imo, that German - and Swiss, like the announcement yesterday from Ernst Tanner, CEO at Lindt & Sprüngli - companies believe the USD and the US economy will remain weak for a long time to come.
