In Dire Need of 'Positive Economics'

The wild down turn in financial markets in the first 2 weeks this year has added fuel to talks of recession and has significantly dented already weakened consumer confidence. While almost none forecast a recession as late as Q2 2007, we have every one now, from Goldman Sachs to Alan Greenspan, talking about an inevitable recession in 2008. To understand the meaning and need for positive economics, its imperative that we take a quick look at how each of the market stake holders have acted/reacted in the recent past.

The Fed can be right…

Though many would argue, the Fed has been remarkably agile in responding to recent recessions. Back in 2000-01, Fed cut the funds rate from as high as 6.5% in early 2001 to 1.75% by December 2001, with as many as 6 rate cuts in the first half of the year. Similarly, we saw rate cuts in September, October and December last year. Its is important to note that the Fed faces the onerous task of balancing economic growth with inflation risks - fuel prices still stay at 90+ levels, and inflation remains relatively high at 3%+. Despite this, Ben Bernanke, in his recent testimony before the House Budget Committee, quite openly stressed on the need to expedite a fiscal stimulus package to counter the economic slow down. How does the market react to most of this – utter disdain! I, for one, am at a loss to understand why the market would cry foul when the Fed chairman speaks of the need for a fiscal stimulus package. In the current economic situation, what is needed is an all-out effort to contain the slow down and prevent a true recession. It’s really not the right time to speak true-capitalist lingo and paint this as a case of the government or the Fed trying to tamper with market dynamics!

Who’s to blame?

Let’s rewind a bit to get some perspective - who was responsible for the current mess in the first place? As real estate prices artificially rose through most of 2005, ’06 and ’07 from Nevada to California to Florida, market forces were truly responsible for an almost irresponsible build-up in home equity loan portfolios, predatory mortgage lending & heavy fund investments in MBS & mortgage-backed CDO instruments. Almost any asset management entity worth its name peddled ‘active’ Fixed Income funds, a nice-sounding pseudonym for funds focusing on current-flavor-of-the-market instruments – heavily on CDOs and MBS in this case. None of the rating agencies even barely raised concerns of credit quality or attempted down grades in this exuberant market that continued as late as Q2 2007. Fast forward to Jan 2008 and we now have every market participant hating sub-prime and writing off CDO and MBS portfolios like no one’s business. Some key questions come to mind:

• Despite all the data-driven analysis and risk simulation and modeling infrastructure available, why does it take one or multiple quarters of economic slow down before rating agencies raise caution signs and start rating mark downs? There definitely is scope for further improvements in forecasting and simulation technology, but there should be more to it than that! I don’t know the answer to this, except for potential conflict of interest situations and resultant sub-optimal rating calls.
• Along the same lines, none of the equity market researchers did as much as lower targets for the Citis and Merrills of the world till as late as Q3 2007. And when they started doing this AFTER the market showed clear signs of strain in Q4 2007, why was it over-the-board in many cases – take the infamous analyst comments on the ETFC downgrade in Q4 2007, for example. Shouldn’t there be an un-written code of conduct for analyst announcements?
• When every one’s aware of the importance of consumer sentiment and confidence indexes, why is there always a fight for one-upmanship to announce the slow down/recession – AFTER a slow down has started? Except for NBER, almost every other entity has ‘confirmed’ a recession in the last 4-6 weeks! NBER has a history of being very slow in ‘acknowledging’ recession, but at times this might be better than shouting from the roof top and hastening the slow-down process.
• Except for Larry Kudlow (notably), what role is the business media playing in this case? Akin to kicking the fallen opponent in a boxing ring, you have expert after expert predicting drastic market corrections and worser mortgage market conditions in 2008 – AFTER seeing the economy slowing down.
• Why does the market necessarily be on collision course with the Fed/government? When ever Ben Bernanke speaks, the market loves to hate him. If he announced (quite reasonably) that this economy needs a fiscal stimulus Viagra, why does the market cringe and crib?

The need for responsibility…

The key point is – doesn’t every true market participant have the right to temper market gyrations and at least strive for market sanity? The danger of self-fulfilling prophecies and the importance of market sanity are best apparent in the below case:

Thanks to a high level of integration (and hence, inter-dependence) of markets across asset classes and geographies, one (or was it two from Bear Stearns?) sub-prime fund bust causes the global high-yield debt market to panic. Financial institutions react with drastic cuts in non-prime lending and aggravate the already weakened mortgage market. This in turn caused increased defaults, and thus further depressed CDO and MBS papers backed by sub-prime debt…causing massive write-offs by major financial firms, lead by C & MER. With the potential defaults and losses on mortgage-related portfolios clearer, panic sets in on bond insurers and you see MBIA and AMBAC tumbling 70%+ plus in a span of weeks. This in turn triggers further write-downs in both CDO/MBS and mortgage loan portfolios of multiple financial entities. And the story continues – or does it?

We need to know that most of these write-offs can in fact reverse to profit bookings once some of the mortgage market fundamentals start picking up again and bad paper suddenly turns not-so-bad as collateral values inch back and LGD values decline. Now, how does the market rise back? Only through more mortgage market activity and hence, increased consumer confidence; this can be driven significantly by fiscal stimulus packages to aid delay/prevention of fore closures. I do agree that it’s wrong in principle to reward people who have been reckless in the first place by going for unaffordable loans and endangering their financial standing. But are they more at fault than sophisticated market players who willingly aided/led them in this path – that’s a difficult question indeed to answer for many market analysts.

‘Positive’ economics…

So, what’s the whole point? Simple – we need to embrace ‘positive’ (as against normative) economics and react with root-cause correction instead of following a throw-the-baby-with-the-bath-water approach. It would be a saner market if researchers (and analysts, if possible) focus on root cause analysis and highlighting risk factors, and hence risk mitigants, instead of making market-driven first-to-the-table judgement calls. Along the same lines, credit and capital market participants need to have self-governing code of conduct and ethics in analyst announcements and research publications that affect the broader market. The media needs to play a more constructive role by focusing on positive steps being taken by the Fed, government and market forces in facilitating a smoother landing (and a quicker take-off). The market needs to be more flexible to Fed and government tactics to counter recessions – and not stick to a stubborn ‘no-fiscal-policy’ stand. I am NOT a proponent of governmental control, but neither do I believe that a free market can always be self-correcting!

We all know the US market can really NEVER be on a firm footing with out correcting fundamental problems related to low consumer savings and high fiscal deficits – but that’s an altogether different discussion in itself! While our leaders strategize for that big battle, why not market and legislative forces work constructively to react to this slow down?

Quick note: The word ‘Positive economics’ is a bit loosely used here, not necessarily matching with Milton Friedman’s classic economic theory advocating free-market economy with high focus on monetary policy and low governmental influence

Disclosure: None