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

by: Tim Duy

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

Graph 1

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

Graph 2

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:

Graph 3

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

Graph 4

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:

Graph 5

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.