What Will It Take for Faith in Financial Engineering to Wane?

The data flow is truly horrible, painting a picture of an economy so weakened that it promises to engulf the recently passed stimulus package. Fiscal authorities will be pushed to do more, and President Barack Obama recognizes the challenges and opportunities presented by this recession. His recent budget proposal sets the stage for a bitter fight on the magnitude and composition of the government’s role in the macroeconomy. Monetary policy will also be asked to do even more as well, and the question remains the same as last fall when it became clear the Fed was headed to the zero bound - when will Bernanke & Co. shift gears to an overtly inflationary policy direction? When will the focus of policy shift from the asset side of the balance sheet to the liabilities side?

Last week’s revision to the 4Q08 GDP numbers was a fitting testament to the sad state of economic activity; the -6.2% dive in output is shocking:

click to enlarge

The composition of growth also speaks to the damage to virtually every sector of the economy:

The only meaningful growth came in the form of import compression, a fall in real imports. To be sure, some import compression was to be expected as the US off-shored some of its domestic weakness, and would be consistent with a rebalancing story. But to be desirable, the compression would need to be moderate, signaling a softening of domestic demand - not a collapse. Moreover, the rebalancing story required that export growth offset some of the domestic weakness; the global meltdown ended that story fast and hard. Relying on the rest of the world helped Japan stagger through the last two decades; that support is no longer available to the US - or anyone, for that matter.

Moreover, despite the magnitude of the fourth quarter drop, and the time already spent in recession (over a year according to the NBER), there is no sign that conditions are likely to moderate in the first half of this year; we are all simply hoping that cyclical dynamics wane and that fiscal stimulus meaningfully supports growth in the second half of the year. Note that the January read on durable goods indicates a downtrend in investment that is more consistent with the early stages of a recession, not the latter:

Likewise, one of my current personal favorite charts illustrating the collapse of demand at the end of last year, the inventory to sales ratio:

It is as if a decade’s worth of efforts to improve inventory management disappeared in a single quarter. Note this indicates that the small inventory accumulation in 4Q08 does not suggest improvement as firms rebuild inventory early this year; firms clearly need to continue shedding inventory well into 2009.

Commentators quickly noted the GDP figures were the worst since 1982. Normally, that could be seen as comforting; how much worse can it get? Only upside left, right? If only that were the case. First, as I noted above, much of the data we saw at the end of 2008 was typical of an economy just heading into recession, not one that had already been in recession for nearly a year. The early stages of this recession were so mild they could barely be called a recession; it was only after the triple collapse of the US consumer, investment spending, and the global economy late in 2008 that the textbook recession dynamics took hold. Second, not only did those dynamics take hold, they took hold with an unprecedented severity (at least with respect to the post-war data). And third, unlike 1982, there is no room left for conventional monetary policy.

This last point is often lost on the general public. I am often told by some “old-timers” that they remember the early 1980s and how it was much worse, inevitably remarking on the high level of interest rates at that time. The response, of course, is that with high interest rates, there was amazing room for monetary policy to stimulate activity. Indeed, high rates in the 1980s provided the room to support a 25 year consumer spending boom that only ended when savings rates finally hit the lower bound:

Which brings me back to the original question - having spent down conventional monetary ammunition over the past 25 years, when does Federal Reserve Chairman Ben Bernanke revert to an overtly inflationary policy? The answer: When he no longer believes there is a way to financially engineer the US (and global) economies out of the current environment. Then you are left with only two options - sit back and allow deflationary forces to take hold (a true liquidationist position), or initiate the time honored process for eliminating a debt overhang, inflation.

But Bernanke has not given up hope, audacious though it may seem, that the answer is financial engineering. Yves Smith noted last week:

…What is amazing is the degree to which Bernanke has been unable to process what has happened over the last year and a half. It isn’t simply that he is trying to restore status quo ante; he seems to see the only possible operative paradigm as the status quo ante. Worse, he has a romanticized view of it too.

We had a massive stock market bubble, followed by an even bigger asset orgy, with housing at the epicenter, but plenty of other types got dragged along with it. Having asset appreciation fueled by debt is NOT how a healthy economy operates. It is going to take some time for the excesses to work themselves through…

This reminded me of a Bernanke speech from 2005:

Some observers have expressed concern about rising levels of household debt, and we at the Federal Reserve follow these developments closely. However, concerns about debt growth should be allayed by the fact that household assets (particularly housing wealth) have risen even more quickly than household liabilities. Indeed, the ratio of household net worth to household income has been rising smartly and currently stands at 5.4, well above its long-run average of about 4.8. With real disposable income having risen over the past few quarters, most consumers are in good financial shape–a positive indication for household spending. One caveat for the future is that the recent rapid escalation in house prices–11 percent in 2004, according to the repeat-transactions index constructed by the Office of Federal Housing Enterprise Oversight–is unlikely to continue. A plausible scenario is that house prices will either move sideways or rise more slowly during the next few years, eventually bringing the rate of return on housing in line with the relatively low prospective rates of return that we currently observe on virtually all assets, both real and financial. If the increases in house prices begin to moderate as expected, the resulting slowdown in household wealth accumulation should lead ultimately to somewhat slower growth in consumer spending.

Leaving aside the issue of housing prices for a moment, consider the issue of household net worth. I always feel that academics misinterpret balance sheets, particularly household balance sheets. Here Bernanke is saying that debt is not a problem because it is matched by an asset of equal or greater value. Ergo, you have positive net worth, so everything is good. But that debt needs to be supported by a positive cash flow, and the many assets on household balance sheets generally do not generate cash flow, especially owner occupied housing assets. This differs from a corporate balance sheet, where the assets are supposed to be combined in some fashion that generates a positive cash flow.

The cash flow that supports most household debt is independent of assets; it is the result of employment income. To be sure, perhaps some of those assets support the employment, such as a car. But even in this case a Toyota Camry performs the same function as a Lexus. Claiming the latter is necessary for employment is largely a fantasy.

Bernanke praises the power of the household balance sheet, and further supports his contention that households are financially strong by the disposable income growth at the time. What he missed, however, was the importance of declining savings rates, which were quickly converging on zero. When saving rates hit zero, free cash flow for households is gone, and without free cash flow, the ability to increase debt diminishes unless either interest rates fall further or we can divorce credit access from ability to repay. In this speech, Bernanke effectively endorsed the illusion that asset value growth could replace ability to repay for underwriting purposes. Debt accumulation and thus spending can be supported indefinitely as long as asset values increase.

I suspect that Bernanke still believes his basic framework was correct, even if underwriting conditions loosened more dramatically than desirable. But with saving rates at zero this system was remarkably vulnerable to negative shocks to the consumer. This, I believe, is one of two fundamental failures of the Bernanke system. The first negative shock was the housing slowdown. Again ignoring the housing price declines, just leveling prices was, as Bernanke indicated, sufficient to limit the debt accumulation that supported additional spending, and left spending to growth at the disappointing pace consistent with income growth. But income growth was sure to slow as job growth slowed in response to housing and there was little in the way of easily accessible savings to compensate. In addition, households were hit with a massive energy price shock and, with no room in income left to compensate, spending was forced to drop dramatically.

In short, by minimizing the importance of low saving rates (a cash flow issue) and emphasizing the role of increasing asset values (a balance sheet issue), Bernanke fundamentally misunderstood the vulnerability of households to negative shocks to real income.

Now, however, saving rates are positive, albeit still very low by historical standards. Still, there would be room for economic traction by bringing saving back down to zero. Harder than it sounds as, unlike 1982, we have limited room to reduce interest rates to encourage spending. Moreover, household net worth is now eviscerated by housing and equity price declines, that consumers are cutting back in a desperate struggle to deleverage and rebuild net worth. It is on this latter point that I believe the economic leadership in the nation still believe there remains possible policy traction.

The collapse in housing prices was the second fundamental blow to the Bernanke framework; note that an actual decline in housing prices was not in his forecast. So the key to restoring growth, in the Bernanke framework, lays in restoring housing prices, and asset prices in general. This is the focus of policy - if we can jump start the debt markets, we can rebuild asset prices, and thereby encourage a rebound in consumer spending. This is, again, a balance sheet approach to household finances, and ignores the importance of tighter underwriting conditions, not to mention that this approach is limited as, over the longer term, if savings rates were forced back to zero, consumers will be pushed back from one precarious position (weak economy) to another (no savings cushion).

Leaving aside those challenges, another problem is the one which Yves alludes to - the persistent belief that current asset prices are currently “wrong.” There appears to be little thought given to the likelihood that past prices were “wrong.” Instead, policymakers appear to believe that prices have intrinsic values. The trick is to get market participants to recognize those values. The belief (delusion) that the current price is simply wrong is not limited to Bernanke; it is pervasive among policymakers. James Kwak directs us to an interview with Treasury Secretary Timothy Geithner, commenting:

The idea that houses have a “basic inherent economic value” other than the prices they can fetch in the housing market is, I think, a fallacy. And so the idea that therefore houses will naturally return to some “basic inherent economic value” that is higher than current market prices is, I think, wishful thinking of the kind that has hampered responses to this crisis from the beginning. They could; but they could just as well not.

The saddest part of policymakers who cling to the notion of intrinsic housing values is that economists long ago rejected the notion that such prices existed when they rejected the labor theory of value. Is Bernanke a monetarist, neoclassicalist, or a Marxist? Value is determined by a constellation of social conventions at some point in time. If the social convention is that financing is limited by ability to repay, then cash flow (largely income), not asset appreciation, is the appropriate metric for valuing houses. “Restarting” the credit markets alone will not alter this convention; it was the willingness to disregard this convention that was the fundamental failure of credit markets.

This is not meant to imply that restarting credit markets is not a worthy effort. The opposite is true; functioning credit markets are important to economic growth…but functioning likely means a return to conventional underwriting metrics, and thus housing prices will remain depressed. Indeed, I think a good argument can be made that, under conventional norms, homes price should decrease until mortgage payments are less than the rental equivalent (after accounting for the hassles and costs of home ownership).

Policymakers are assuming that restoring proper functioning in credit markets - and confidence in general - is equivalent to a housing price rebound. They seem incapable of envisioning a world in which this is not the case. This tunnel vision prevents policymakers from trying to devise policy which assumes that many of the assets in the banking system are simply “bad.” For Bernanke and Geithner, there are no bad assets. Only misunderstood assets.

And therein lies the key to predicting when the Fed shifts gears; when Bernanke abandons the notion that proper credit market functioning is alone sufficient to restore housing values (asset values more generally) to their former glory and support acceptable growth. At that point, the Fed will again consider the wisdom of what it has defined as quantitative easing, an expansion of the balance sheet via a deliberate expansion of liabilities. Until then, we can expect the Fed to continue its focus on financial engineering.

Comments

[Jason Laurent:]

Great article. The emphasis on cash flows is right on point. That's what intrinsic value is all about. The rest is mostly the anticipation of future capital gains, which seem almost a given in a risen market, especially the steroid-abusing bull we just came out of

Mar 02 05:26 PM

[Vuke:]

Tim, I don't know if Bernanke reads SeekingAlpha, somehow I suspect he's busy with other things, but I'm pretty sure he no longer embraces his "basic framework" as you declare.

In fact, I think he's staring in horror at a a blank slate while feverishly figuring his next step. If he does read SA then I'd advise him to get as much new paper out there, in any reasonable way he can, before this thing turns into the Mother of all Horror Stories. There are still shiploads of mummified derivatives floating out there that will never see daylight again.

Getting lost in the sideshow of housing prices or rental rates is the mere tip of the iceberg in the juggernaut of bad debt bearing down on the Ship of State. Walt Whitman, were he alive, would alter his poetry somewhat to accomodate the dying dollar rather than the death of Lincoln.

Captain! my Captain! our fearful trip is done, The ship has weather'd every rack,
the prize we sought is won, The port is near, the bells I hear, the people all exulting,
While follow eyes the steady keel, the vessel grim and daring; But O heart! heart! heart!
O the bleeding drops of red, Where on the deck "The Dollar" lies, Fallen cold and dead.

Mar 02 05:27 PM

[waf76:]

With the market so pessimistic and rightfully so I can't help but to be finally contrarian. At some point the fed will raise rates. Job loss will continue, after all it is a lagging indicator. Real salary will rise as a result along with a strong dollar creating consumer purchasing power which will cause asset price to rise and lending too.

Mar 02 05:42 PM

[User 316043:]

Corporate America has done a wonderful job compressing wage growth and wealth growth(aka as eliminating retirement benefits) leaving consumers stressed by declining incomes and putting retirement beyond the horizon. The availability of easy extraordinarily cheap debt (thanks to Greenspan and company) of all types that was available to these stressed consumers (who also had no motivation to save because of lack of real returns) fueled a era of consumption and housing purchases/up grades that was unsupported by income levels. Plus the
availability of mortgage money for speculation was wild. Working americans need more income,NOT more credit. It apears that most of the government actions appear to be directed to allowing financial institutions to off load bad assets

Mar 02 05:52 PM

[happysoul77777:]

Why do you guys keep looking at the symptons?
If you can get your Congressmen do the following things, I'll guarantee that the market will exploded in two weeks:

Please write or call your congressman or congresswoman to introduce legislation to:


1. Modify the FASB 157 (mark-to-market accounting rule) to allow financial institutions to spread losses over the average life of their investments, rather than taking losses immediately even though the losses may be due to lack of liquidity. (The modification will lessen the negative impact of the rule on banks’ capital, but still rigorously require banks to deal with potential losses.)

2. Prohibit FASB accountants, SEC staff that are responsible for formulating accounting and trading rules from investing in hedge funds, or engaging in any short selling activities (to safeguard the integrity of the market.)

3. Re-instate the uptick rule to prevent bear raids (to prevent piling on and to lessen volatility.) The repeal of the uptick rule allows the synchronization of futures, options and stocks and the focus of selling including short selling on a few leading stocks. The sharp declines in a few leading stocks will create fears and uncertainties, and hence affect the sector, and eventually the whole market.

4. Eliminate loopholes in the legislation that allows naked short selling.
(The market makers currently can create counterfeit shares (phantom shares) to sell short any stocks for two days before they have to deliver the borrowed shares or close out their short positions.) Those who want to sell short must borrow in advance.

Mar 02 06:20 PM

[MarvinMBA:]

The Economic model that our great USA has been operating on for years is in utter shambles. Little pieces are all over the place and Uncle Sam is now also a piece of the action.
Old metrics are gone and any attempt to reconstruct our economy on history is doomed to failure.
We are in a new ere that is unfolding and even those that are pushing the buttons do not know what is going to evolve.
Trying to predict future economic trends at this time and place is a utter waste of time because we are still going thru the destruct cycle.

Mar 02 06:51 PM

[Tesa:]

I like to note that many goods are not long lasting. The car industry has seen a massive hit but the 2nd hand vehicles and older trucks would be maintenance hungry. I wonder if there are sufficient number of mechanics to even take care of aging fleets. When the surplus cars in the market get absorbed, then there is no doubt in my mind that the demand will be a large even as the economy is faltering because many consumers are used to non maintenance free vehicles.

We have a market that is frozen which can flip when it hits an under supply of goods.

Mar 02 07:11 PM

[Tetrapod:]

Very good article!
I agree with Ergo above that the problem hasn't been so much irresponsible consumers buying frivolously, but an insidious reduction in real income of middle class Americans. It happened very slowly such that many families that had been able to afford a house, two cars, good food, etc. didn't realize until too late that they were no longer able to live in the lifestyle that they were used to. The housing bubble let the mirage go on for a while longer. Now we have to go throught the painful realization that being a professional making $100K+ a year doesn't mean you can afford to own a home and raise a family in many parts of the country.

Mar 02 07:45 PM

[Tim Gluck:]

What the author means is that, In the early eighties, interest rates were very high. Because they were high, the fed had the ability to lower them from the High level to much lower levels. Since rates are now near to zero, they cannot be lowered substantially and therefore, are ineffective at stimulating more borrowing.

On Mar 02 04:00 PM Dissenter wrote:

> I liked this article but can someone explain to me how high interest
> rates stimulate the economy? And if this is true why isn't the government
> pursuing a policy of high interest rates now?
>
> "The response, of course, is that with high interest rates, there
> was amazing room for monetary policy to stimulate activity. "
>
> I thought low interest rates stimulated borrowing which stimulated
> the economy whereas high interest rates did the opposite and put
> the brakes on an expanding on economy.

Mar 02 08:03 PM

[prudentinve...:]

Tim, Excellent article, very well written. I wish our legislators would read it.

At some point, it should become clear that a healthy economy is based on the value of its productive labor, not its conjured asset values. Measures to re-stimulate the economy must be directed at creating skills, good jobs, and good incomes for the populace.

The origin of this crisis is in the misguided approach that we just need to facilitate greater debt, rather than better income, earned by better skills, and by old fashioned hard work. Greater debt will not help, and printing money and scattering it from helicopters will not either.

Mar 02 08:10 PM

[speedstream...:]

An excellent article from a great professor. His 101 class was as interesting as this article.

Mar 02 08:56 PM

[@TexasER:]

Wonderful article. This line is priceless:

"For Bernanke and Geithner, there are no bad assets. Only misunderstood assets."

Dead on.

Mar 02 11:04 PM

[Dave Wrixon:]

He is merely talking about the scope to shift them down. If they are high you have it, if they are low you don't.

Good article, it gets a bit technical about the basic folly of ignoring asset price booms when setting interest rates but very insightful, even if some here are struggling with basics.


On Mar 02 04:00 PM Dissenter wrote:

> I liked this article but can someone explain to me how high interest
> rates stimulate the economy? And if this is true why isn't the government
> pursuing a policy of high interest rates now?
>
> "The response, of course, is that with high interest rates, there
> was amazing room for monetary policy to stimulate activity. "
>
> I thought low interest rates stimulated borrowing which stimulated
> the economy whereas high interest rates did the opposite and put
> the brakes on an expanding on economy.

Mar 03 01:07 AM

[Moon Kil Woong:]

There is no reason to have faith in the system because fundamentally nothing has been done to fix the financial problems that created the distrust in the first place. We need real regulation, a return to Glass-Stegal, force brokerages to pay the government for covering their ass in a downturn, real enforcement, closing holes that allow banks to keep losses and assets off balance sheet, and to wipe out all bankrupt too big to fail financial/insurance titans. That way we can get the bad banks real management open their books and start to sanitize their gobs of bad investments.

Throwing money at the system is wasteful and proves the government is still in denial and is unwilling to apply real effort to fix the situation (that means pissing off bankers by passing legislation to stop them from doing egregious acts).

Mar 03 01:23 AM

[Steven Hansen:]

"we can expect the Fed to continue its focus on financial engineering."

tim, nice well thought out piece. you cannot expect the fed to focus on anything other than financial engineering because that is their expertise. they understand housing dynamics from a quantitative point of view, but not from the view of what the customer wants or desires.

Mar 03 01:50 AM

[Moon Kil Woong:]

Tim Duy your statement is so true: "For Bernanke and Geithner, there are no bad assets. Only misunderstood assets."

The issue I point to is that the financial system needs to reform itself to prevent the accumulation and deferral of losses when bad assets crop up. This also strengthens the economic system and restores faith and confidence. Right now the government is only fiddling with cosmetics and not dealing with the fundamental structure that precipitated this recession.

Mar 03 02:35 AM

[morph366:]

An excellent article.
As you point out the 1980's recession at least had the silver lining in that interest rates after Mr Volcker had done his task could be lowered substantially and that paved the way for the bull market that began in 1982/3. We are clearly not is anything like the same situation today.
Most importantly you are right to stress that asset price valuation models should be predicated on the basis of cash flows and income rather than on using asset appreciation and balance sheet items to support higher valuations.
In the future values in the residential real estate market need to be anchored firmly in a sustainable, and historically proven, relationship between median home prices and median income. Allowing capital appreciation and equity release reasoning to be factored into higher home valuations adds a major element to the risk equation, which will be even further exacerbated in the future, as not even the homeowners' income can be relied upon in the employment environment that we should expect even after the worst of this recession is over.

Mar 03 08:26 AM

[kdo:]

I think part of the problem is thus. Economic models exist which show clearly that expectations of price increases, can lead to further price increases (inflation) and that can be modified through interest rates, same with deflation, which provide feedback loops. However, the knuckleheads (economists) give way too much credit towards people to price assets and don't understand that asset price behave in the exact same way. So if people become habituated to price increases, they're expectations of price increases start creating a self fulfilling prophecy (ie: I will pay more today because I expect it to be much higher next year), just like the prices of stuff. But what to do? Clearly, it should not be the provence of the government or central bank to declare what prices should be and having a stated policy of "stable asset prices" is wierd and kind of socialist. However, especially when people are taking on too much debt to buy overpriced assets, there is a huge problem brewing that needs intervention.

Mar 03 11:16 AM

[yank:]

Happy:
Your post was simply outstanding. The complete "inertia" of the SEC and other regulators in the face of these brutal market declines seems to indicate they either:
1. Are incompetent.
2. Indifferent to concerns over market "stability"
3. In the pocket of hedge funds.

Not sure which of the above applies but if something doesn't happen soon we will see a Dow below 5,000 before long. It is incredible to me that I saw on CNBC this am that Geithner is rolling out a new TALF plan that will in essence be throwing more money at hedge funds so they can "play" their capital destruction game. The core of the new TALF program is "securitizing" debt. Does anyone else find this incredibly corrupt and stupid? Securitization is what has unleashed this chaos and instability and Geithner wants to go right back into the "soup". This guy is so NOT ready for Primetime. Sorry.

Yank


On Mar 02 06:20 PM happysoul77777 wrote:

> Why do you guys keep looking at the symptons?
> If you can get your Congressmen do the following things, I'll guarantee
> that the market will exploded in two weeks:
>
> Please write or call your congressman or congresswoman to introduce
> legislation to:
>
>
> 1. Modify the FASB 157 (mark-to-market accounting rule) to allow
> financial institutions to spread losses over the average life of
> their investments, rather than taking losses immediately even though
> the losses may be due to lack of liquidity. (The modification will
> lessen the negative impact of the rule on banks’ capital, but still
> rigorously require banks to deal with potential losses.)
>
> 2. Prohibit FASB accountants, SEC staff that are responsible for
> formulating accounting and trading rules from investing in hedge
> funds, or engaging in any short selling activities (to safeguard
> the integrity of the market.)
>
> 3. Re-instate the uptick rule to prevent bear raids (to prevent piling
> on and to lessen volatility.) The repeal of the uptick rule allows
> the synchronization of futures, options and stocks and the focus
> of selling including short selling on a few leading stocks. The sharp
> declines in a few leading stocks will create fears and uncertainties,
> and hence affect the sector, and eventually the whole market.
>
> 4. Eliminate loopholes in the legislation that allows naked short
> selling.
> (The market makers currently can create counterfeit shares (phantom
> shares) to sell short any stocks for two days before they have to
> deliver the borrowed shares or close out their short positions.)
> Those who want to sell short must borrow in advance.

Mar 03 12:18 PM

[henarl:]

I think you're seeing faith in financial engineering waneing right now. Take a look at the market indexes. The government may still profess to have that faith but the public is not buying it.

Mar 03 05:49 PM