Like 2008, but without the banking crisis
Friedman and Schwartz showed that if the Fed remained passive in the face of rising demand for base money, then they were effectively tightening money policy. This was essentially my argument about the fall of 2008. During the late 2008 banking crisis the Fed remained too passive in the face of a huge increase in the demand for liquidity. Thus caused deflationary expectations to set in, which caused crashes in all sorts of asset markets, and the falling asset prices greatly intensified the financial crisis.
The conventional view reverses the causation. The US financial crisis is viewed as an exogenous real shock, which actually caused the big drop in NGDP.
Let me say right up front that I don’t expect a double dip recession, nor do I believe the markets expect this to occur. On the other hand I also think it is clear that the risk of a double dip recession has recently risen, let’s say from 5% to 20%. (Yes, I’m pulling these numbers out of a hat, just to give you a sense of what I think the markets are telling us.)
Suppose I am right, and that an increase in the demand for dollars, plus Fed passivity, recently made monetary policy effectively more contractionary. Here’s what you’d expect to see in the financial markets:
1. Falling commodity prices
2. Falling TIPS spreads
3. Falling equity prices
4. An appreciating dollar
Here’s what I have recently noticed (from Yahoo.com):
Oil prices rose to near $78 a barrel Friday, halting an 11 percent sell-off this week as the euro recovered against the dollar and world stock markets steadied.
So oil has fallen sharply this week. I wasn’t able to find a graph of TIPS spreads, but this Yahoo table shows that 5 year bond yields have recently fallen 55 basis points, and I believe that 5 year TIPS yields have been much more stable. Thus implied inflation forecasts have recently fallen from well above 2% to well below 2%.
| Maturity | Yield | Yesterday | Last Week | Last Month |
|---|---|---|---|---|
| 3 Month | 0.08 | 0.13 | 0.14 | 0.14 |
| 6 Month | 0.15 | 0.20 | 0.22 | 0.24 |
| 2 Year | 0.77 | 0.86 | 1.00 | 1.13 |
| 3 Year | 1.27 | 1.39 | 1.54 | 1.70 |
| 5 Year | 2.15 | 2.29 | 2.45 | 2.70 |
| 10 Year | 3.40 | 3.54 | 3.73 | 3.95 |
| 30 Year | 4.20 | 4.39 | 4.59 | 4.83 |
I don’t think I even need to tell you what has been going on with the stock market:
| Want more control over the chart? Try our Interactive Chart | |||||
Of course there has been a lot of focus on the sharp downward spike at 2:45 yesterday afternoon. Apparently there was some sort of glitch in electronic trading. Although I know next to nothing about this issue, let me throw out a hypothesis as to a possible contributing factor. Notice that even before the glitch, the market was falling at an accelerating rate. Perhaps the impact of the error was bigger than normal because it occurred in a very sensitive period (from the perspective of technical analysts.) And why might the market have been falling sharply even before the glitch? Take a look at this graph of the euro/dollar exchange rate:
This graph uses GMT, which is 5 hours ahead if I am not mistaken. If any of you are better investigators than I am, perhaps you could check to see whether the sharp plunge in the euro (to below 1.26) occurred around 6-7:30 GMT (or 1-2:30 pm EST.) Just eyeballing the graph it does seem to have occurred at about that time. Perhaps the plunge in the euro weakened stock prices right before the glitch, leading traders to think (for several minutes) that the sharp plunge in the DOW might be real.
In any case, it is clear that all four variables behaved much as you’d expect if the Fed adopted a tighter monetary policy. Of course the real reason was Fed passivity, but the effect was the same. All of these things also happened (to a far greater extent) in October 2008. If the market reaction doesn’t get any worse, we almost certainly won’t get a double-dip. But the market has pretty clearly signaled that its consensus forecast of NGDP growth over the next few years is a bit lower than the implicit forecast from a month ago. And that’s not good news.
A few months back the blogger Ambrosini asked why I don’t give up my push for easier money. The damage has already been done. He didn’t say this, but the implication was that I risk looking like a crude inflationist. I have some sympathy for that argument. But here’s something to think about. Rates are still near zero. That means the Fed still cannot use conventional tools to offset any renewed weakness in the economy, coming from something like a crisis in Europe. Yes, they could and should use unconventional tools, but they have already proved unwilling to use higher price level or NGDP targets back when the need was even greater than today. I really can’t feel comfortable about our situation until the economy is strong enough to push rates above zero. And we are not there yet. Sure the Fed could artificially raise rates above zero right now, but that would be madness given that near term NGDP growth is already likely to be far below target. Indeed 2 year TIPS spreads are still far below 2%.
Here’s something else to think about. The people who think my “nominal shock” model of the 2008 crisis is naive, tend to view financial crisis as a real shock. Banking turmoil makes it difficult to get loans, and hurts business and residential investment. OK, but then explain the last few weeks. The problem is now Greece; the US banking system is just as able to dole out credit as it was a few weeks ago. So why are the markets signaling lower inflation and lower real growth than a few weeks ago? In other words, why has AD dropped slightly? The answer is that monetary policy has effectively tightened due to an increase in demand for dollars.
As I keep emphasizing, tight money always looks like something else. Back in 2008 I can certainly understand why people would focus on the highly visible financial crisis, and not the much more invisible impact of rising money demand (or falling velocity.) But does anyone really believe that the real effects of a debt crisis in tiny Greece (or even Spain) could have produced the sort of large swings we have recently seen in equities, TIPS spreads, oil prices, etc? The last few weeks have been like a miniature version of the October 2008 crisis, but without the US banking panic. And the effects were qualitatively similar.
PS. I am not arguing that the euro and Dow are always positively correlated. When the Dow rises for supply-side reasons (as during the 1999-2000 tech bubble) the euro may well weaken. The correlation occurs when monetary conditions are driving the market.
Update: I just noticed that this video makes a similar argument.
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7. May 2010 at 06:20
Mismanagement of monetary policy and the real banking shock were two main causes of 2008 crisis. What we are seeing this week is a slight increase of a risk of a new systemic banking crisis in Europe. To a large extent it can be offset by an additional monetary stimulus in the US, but there are some real elements too – trade linkages with Europe and a risk of transatlantic financial contagion.
7. May 2010 at 07:59
Do you blame the European Central Bank for the PIIGSs debt crisis?
7. May 2010 at 08:13
In my opinion I think the Fed is refusing to use unconventional tools because it fears that its credibility in its exercise of monetary policy would be shaken. Ironically refusing to do anything in response to shifts in money demand is only raising the general sense of panic. Days like yesterday should give us all pause.
7. May 2010 at 09:13
Maybe the better solution is to decrease the demand for base money through smart policy rather than increase the supply of base money. There is no confidence in the world right now because policies are hopelessly backward-looking and fraudulent. Your solution to a withdrawal is to give the patient more drugs – i dont get it.
7. May 2010 at 10:47
‘Friedman and Schwartz showed that if the Fed remained passive in the face of rising demand for base money, then they were effectively tightening money policy. This was essentially my argument about the fall of 2008.’
‘The conventional view reverses the causation. The US financial crisis is viewed as an exogenous real shock, which actually caused the big drop in NGDP.’
My previous argument about dispersion in the distribution of the change in price levels for the basket of goods that makes up whatever the fed targets… also is an argument that the supply side shock and demand side shock are essentially the same effect in this case.
In a perfect inflation targeting regime, constricting of the money supply would be indistinguishable from the following combined effects:
a) An adverse supply shock in goods with very low elasticity of substitution with the dollar for store of value.
+combined with
b) An adverse demand shock for goods with high elasticity of substitutability with the dollar for store of value.
This would come from the dispersion narrowing in inflation rates among different items.
My unscientific evidence for this is memory sticks rising in price unexpectedly last year.
I really probably should write a paper about this, the more I think about the dispersion, the more I important I think it is.
7. May 2010 at 10:55
[…] SUMNER is always interesting:Suppose I am right, and that an increase in the demand for dollars, plus Fed passivity, recently […]
7. May 2010 at 11:54
Scott,
“But does anyone really believe that the real effects of a debt crisis in tiny Greece (or even Spain) could have produced the sort of large swings we have recently seen in equities, TIPS spreads, oil prices, etc?”
Er, yes. The debt crisis in Greece is perceived by the market as a threat to the financeability of deficits in a number of Euro sovereigns – from the small (Portugal, Ireland) to the large (Spain). These countries continue to run large deficits and have no benefit of Sumnerian monetary stimulus. The scale of fiscal adjustments they need to make are almost unprecedented (without their own currency, no less), and all being done against a background of sluggishness. The banking sector across the continent is widely exposed and is at risk of a run.
Now, none of these threats need materialize….but as it seems more likely that they could, that should raise the risk premium for holding equities, credit, etc.
“The last few weeks have been like a miniature version of the October 2008 crisis, but without the US banking panic. And the effects were qualitatively similar.”
The effects may have been similar – but the causes of October 2008 (as you so eloquently have demonstrated) were first and foremost one of liquidity; in this case, there are real solvency threats. And the scope of the problem suggests that nominal solutions (within the range of reasonable inflationary outcomes) are unlikely to be able to paper it over.
And by the way, when Greece first says “restructuring”, a banking panic is quite likely.
Having said all of that, I would be grateful if you could send your blog to JCT and the other “wise men” at the ECB who think a strong euro was a good idea when important member states were running 15+% unemployment and recovering from overinvestment in real estate.
7. May 2010 at 15:53
123, Yes, there are a few real linkages, but I think the fall in US NGDP expectations is the main worry of the markets.
Philo, Both are to blame. Most of those countries have either fiscal or structural or regulatory problems, but the ECB policy made the crisis occur sooner and with greater intensity.
Mark Sadowski, I agree.
mlb, I agree. We should put a penalty rate on excess reserves, which would dramatically reduce the demand for base money. We should also set a higher NGDP growth target, which would also reduce the demand for base money. I think it is foolish to try to solve these problems merely by increasing the supply of base money.
Doc Merlin, Price dispersion does occur, but I’m not sure I’d view it as a supply shock.
ScottSumnerfan, Those are good points (as I would expect from someone named ScottSumnerfan) but I think they apply more to Europe than the US. Certainly the Greek economy will experience a strongly negative real shock, and perhaps to a lesser extent Spain will suffer as well (that isn’t yet completely clear.) But I was thinking about US markets, and I still think the impact is mostly from lower NGDP growth expectations, not real effects.
You said;
“The effects may have been similar – but the causes of October 2008 (as you so eloquently have demonstrated) were first and foremost one of liquidity; in this case, there are real solvency threats. And the scope of the problem suggests that nominal solutions (within the range of reasonable inflationary outcomes) are unlikely to be able to paper it over.”
I have an open mind on this, but my inclination is to think there were solvency problems in both cases (banks then, countries today) and in both cases it led to a increased demand for liquidity, which was deflationary. Just to be clear, I agree that Greece’s problems cannot be easily papered over–as far as Greece is concerned. The Greeks will suffer to some extent almost regardless of what they, or the ECB, or the Fed does or does not do. But I do think that to some extent the collateral damage to the US can be papered over. The Argentine economy is bigger than the Greek economy, but I don’t think their collapse caused much problem in the US, even if some US banks held Argentine debt. It is the macroeconomic effects, not the direct effects of default, that worry me most.
You said;
“Having said all of that, I would be grateful if you could send your blog to JCT and the other “wise men” at the ECB who think a strong euro was a good idea when important member states were running 15+% unemployment and recovering from overinvestment in real estate.”
Thanks. I have recently received a lot of links from Ryan Avent at The Economist. That’s really all I can ask for. The ECB won’t pay any attention to me–I just hope to contribute to the ongoing conversation and get people talking about these perspectives.
8. May 2010 at 08:28
“mlb, I agree. We should put a penalty rate on excess reserves, which would dramatically reduce the demand for base money. We should also set a higher NGDP growth target, which would also reduce the demand for base money. I think it is foolish to try to solve these problems merely by increasing the supply of base money.”
Wow, we are still talking very different languages. To stick with my withdrawal analogy, you are now recommending that instead of giving the patient more drugs you simply give them an electric shock every time they go near drugs. I was thinking more along the lines of actually fixing the patient – therapy, diet, exercise, socializing, etc.
The “mystical” demand for base money that you speak of is not surprising nor random nor undesirable. It is simply a reflection of economic participants’ belief in the future. If an economy is properly leveraged, with balanced sources of consumption & growth, good regulation, and reasonable asset prices, participants will WANT to invest for the future. No need to force them to. Risk-taking is the natural state of affairs unless the ecomonic system is in such bad shape that you have literally beaten it out of the system, which is where we find ourself today.
What economic actors today are actually positive on the future? We have an overleveraged economy, a record inequality gap, massive consumption/savings imbalances, the hand of the govt involved in everything, poor regulatory frameworks, demographic challenges, inflated asset prices (still), etc. The only “bull case” left is that you had better spend b/c central banks are going to make it worthless otherwise. If that is what we are counting on to bring back animal spirits (which seems to be what you suggest) we are in big, big trouble. That is not a cause for optimism but rather a cause for further pessimism.
Once the economic foundation is restored you will no longer have a problem with excess demand for money…quite the contrary.
9. May 2010 at 04:31
mlb, You are mixing up two very different problems. I have never claimed monetary policy can fix real problems. Rather, it can prevent nominal shocks from having real effects. Even an economy with low taxes, budget surpluses, trade surplues, zero inflation, low unemployment, strong investment, small government, rapid productivity growth, etc, can suddenly plunge into a deep depression if monetary policy doesn’t stablize NGDP. Indeed it happened in late 1929. But even if the Fed does stabilize NGDP growth there are all sorts of other real problems to worry about, as you indicated.
9. May 2010 at 15:19
The “real” problem with the economy is that all of the positive nominal shocks have had real effects over the past few decades. Economic actors learned that the path to wealth is essentially be be short negative nominal shocks as the Fed will be there to prevent them. In other words, own assets using leverage and be big enough to be bailed out. Most of our “real” problems can be traced to moral hazard and improper incentives – all in the name of producing positive nominal shocks.
And your answer…produce another huge positive nominal shock.
11. May 2010 at 10:24
“Thus implied inflation forecasts have recently fallen from well above 2% to well below 2%.”
Scott,
You need to get out in the market more. One thing you don’t understand is that everyone doesn’t believe that TIPS are a good inflation hedge andb y treating TIPS as a representation of the whole market you (and everyone who has talked about TIPS the past two years) are systematically excluding the % of the market that believes high to hyper inflation is coming soon.
“But does anyone really believe that the real effects of a debt crisis in tiny Greece (or even Spain) could have produced the sort of large swings we have recently seen in equities, TIPS spreads, oil prices, etc?”
Greece’s GDP is ~340 billion dollars and its debt to gdp is ~125%. If it restructured its debt down to 70% of its current level in a default that would mean a worldwide loss of $127.5 billion dollars overnight. That is roughly equivalent to Fannie and Freddie’s combined losses to this point. Greece may be small as a country- but they are still quite large when compared to companies. Considering that many believe that even a 1/3rd restructuring might not be enough and that up to 2/3rds could be defaulted on the losses could be much higher.
But hasn’t the market known they were in bad shape for some time? Yes, but this leads us to the next point- the EU bailouts. If the markets were pricing in a high chance of being made whole by the EU (say 80%) then you are still potentially looking at 100 billion in losses overnight if the bailout falls apart. If the Greece bailout doesn’t go through then the markets will probably discount the likelihood of the rest of the PIIGS making it through without restructuring. The combined debt levels of Portugal, Italy, Ireland, Greece and Spain is well over 3 trillion dollars. Using a 30% average loss you get $10 billion in expected losses for every 1% decline in the expectation of a bailout.
16. May 2010 at 15:50
mlb, The cost of borrowing reflects expected inflation, so you are wrong about the path to wealth.
baconbacon, You said;
“You need to get out in the market more.”
Ever since I started this blog people ahve been telling me that high inflation is just around the corner. I am confident that I will be proved right over the next few years. I recall the high inflation 70s. I remember when factory workers got 10% raises each year; year after year. Don’t hold your breath for that to happen again.
You said;
“Greece’s GDP is ~340 billion dollars and its debt to gdp is ~125%. If it restructured its debt down to 70% of its current level in a default that would mean a worldwide loss of $127.5 billion dollars overnight.”
Sorry, but that is a trivial amount of money relative to US equity markets. Especially when you consider that the markets weren’t reacting to a $127 billion hit, but just a higher probably of a hit that was already widely feared. The direct impact on US stocks is minor. Much of that debt is held in Europe.
Regarding bailouts, remember that the cost must be paid by taxpayers, mostly wealthier taxpayers. So it’s not clear how that’s a net gain for shareholders.
17. May 2010 at 03:52
Scott,
I have to believe that the sharp drop in US equities was driven by fear and uncertainty regarding a potential breakdown of one of the world’s largest monetary systems – the euro. Now that it appears that the ECB and sovereigns have written a put to the investment community, much of these fears should be relaxed (adjusted for the risk relating to the reliability of that put counterparty, of course).
I guess the hope is that there will be enough real growth over the medium-term to ensure the writers of the put don’t lose too much money on it.
The bearish news for the US should now be the deflationary impact of a euro which trades at much lower value vs the dollar. But that’s still better than a currency run and financial panic in Europe.
Do you counsel now even more QE by the Fed?
17. May 2010 at 06:19
“I remember when factory workers got 10% raises each year; year after year. Don’t hold your breath for that to happen again.”
The inflationistas like to concentrate on the supply of money, but forget about the demand for money. The massive private debt load combined with expectations of poor asset performance (thus driving deleveraging) creates a huge latent demand for money to settle accounts. But instead of using this as an opportunity to print more money and increase capital requirements (to prevent future releveraging), the Austrian crowd seems to be actively seeking the collapse of fiat currencies by doing everything they can to cause deflation, and thus ensure national insolvency.
17. May 2010 at 10:01
“Ever since I started this blog people ahve been telling me that high inflation is just around the corner. I am confident that I will be proved right over the next few years. I recall the high inflation 70s. I remember when factory workers got 10% raises each year; year after year. Don’t hold your breath for that to happen again.”
Your opinion is of little relevance in the matter (other than what you put behind your opinion in terms of $ in the markets). You are using TIPS spreads as a proxy for what the “market” thinks current inflation will be. How many of those people who thought that high inflation was just around the corner was also advising you to buy TIPS as protection? I would bet it would be well under 50%- as everyone that I know prefers to put their money into gold over TIPS. Your position that TIPS reflects the market is incorrect, the TIPS market is made up of people who believe inflation will be manageable in the near future. Those who believe inflation is about to rear its ugly head have driven gold to all time nominal highs in just about every currency. If you don’t realize that there are diametrically opposed viewpoints in the market on this issue then I repeat myself- get out in the market more. If you want to use ‘market expectations’ you should probably understand market demographics.
“Sorry, but that is a trivial amount of money relative to US equity markets. Especially when you consider that the markets weren’t reacting to a $127 billion hit, but just a higher probably of a hit that was already widely feared.”
1. You snipped the fact that there are a half dozen other countries with large problems making the potential losses much higher.
2. Most of the Greek exposure is held by banks. Banks use leverage. ‘Small’ losses cascade with leverage. The French banking system has been specifically cited as having the most exposure to Greek debt- during the crisis weeks French CDS spreads rose the 2nd most (behind the UK) which can reasonably be taken to imply that there is significant fear that a Greek default would lead to bank failures in France which would lead to further problems there (not the only possibility for the move) which would raise the prospects of a French default.
18. May 2010 at 05:11
ScottSumnerfan, I doubt the markets expect the euro to collapse, primarily because it won’t collapse. Worst case is a few countries leave. The euro actually works fine for most eurozone countries, the problem is tight money in the eurozone, not fixed rates. The Mediterranean countries are obviously a separate case. But even there the problems are mostly fiscal in places like Italy, not the euro itself.
I have never thought QE is the best policy. I prefer NGDP targeting, level targeting, and if necessary negative rates on excess reserves. But yes, more QE would be better than nothing, if only as a signal of a higher implicit inflation target.
Statsguy, I sympathize with your point. In fairness, there are many kinds of Austrians, and some buy into my argument that money was too tight in late 2008 when NGDP started falling. And of course there are no Austrians at the Fed. So the problem goes far beyond the Puritan impulse among some Austrians.
But in general I agree that some Austrians seem to root for a collapse of fiat money, rather than making the system work. Being a pragmatist, I find that sort of attitude to be very unhelpful (as it only creates depressions, which leads to statism.)
baconbacon. OK, forget TIPS. Is the US housing market signaling hyperinflation?
That’s a fair point about the other countries. But if the direct effects are so key, why aren’t European stocks falling by much more than US stocks? Are US banks really that exposed to this debt? And why does this hurt the stock prices of US manufacturing companies? And why are inflation expectations falling in the TIPS markets? I am not saying I am definitely correct, but my hypothesis seems to explain the complete picture much better than the standard hypothesis.
18. May 2010 at 06:45
“OK, forget TIPS. Is the US housing market signaling hyperinflation?”
I think you misunderstand my intentions. I am not trying to convince you that hyperinflation is around the corner and I am not trying to convince you to buy gold. My point is that the market is fragmented and that a section of the market is expressing its opinions on the future state of the economy through alternate means. By using measures that represent future expectations that a portion of the market don’t trust/would never use/don’t think is the best way of profiting you are systematically introducing bias into your assumptions.
18. May 2010 at 10:01
Scott said “The Mediterranean countries are obviously a separate case. But even there the problems are mostly fiscal in places like Italy, not the euro itself.”
So you don’t buy Krugman’s story that the lack of labor mobility and absence of fiscal union makes the Euro untenable?
19. May 2010 at 07:32
baconbacon, Fair point, but I see almost everything signalling too little inflation and NGDP, and only gold signalling too much. I see gold as the outlier.
thruth, Yes and no. In a perfect world where the ECB targeted NGDP, I think the euro could work tolerably well. In the real world I don’t think it works well for countries like Greece and Portugal. So I agree with Krugman there. Even in the real world it may work for Germany, France, Benelux, Austria, etc. That remains to be seen. I don’t see an end to the euro, although it’s possible a few countries might leave.