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 March 2009 Debt and Reflation
That's not to say things are completely different this time, they really aren't. But it does mean that there are few precedents that are valid comparisons. Unlike recent recessions that were precipitated by the Federal Reserve raising short-term interest rates to 17% to quash the inflation of the 1970s, the savings and loan crisis in the latter part of next decade, the Asian economic crisis in the late 1990s, and the tech stock collapse at the beginning of this decade, this crisis is focused in the financial market itself. When it was techs or foreign stocks, the financial markets still behaved at least relatively normally. Even when the problem was high interest rates or failing savings and loans, the safety of the major money center banks and government institutions like Fannie Mae and Freddie Mac was never called into doubt. Perhaps more importantly, credit was available, while there may have been few takers. But now, credit isn't available. Lenders are still struggling under the weight of home loan delinquencies, non-performing debt, and derivatives based on both. Those who have cash are hoarding it on their balance sheets so they won't be the target of the next wave of short selling. Those without sufficient reserves are coming to the government for handouts to keep them afloat. This is the core of the problem and what's led to the typical, although more severe symptoms, of recession: Lower production, higher unemployment, and falling consumer confidence. Because the source of the problem is dramatically different, the solution may be as well. Congress, the Fed, and both President Bush and Obama certainly thought so, too. That's why they've been willing to step up the government's involvement and seek the passage of massive spending plans to fight the deepening recession. As we've pointed out before, their approach has been textbook Keynesian. Upon reflection, however, they may be focusing on the theories of the wrong early-Twentieth Century economist.
The Debt-Deflation Theory
Despite their similarities, Fisher differed from Keynes on several key factors. First, unlike Keynes, Fisher believed there were natural economic cycles. While not symmetrically structured like a sine curve or a swinging pendulum, they are constant and repeating. These he called "free" cycles and consisted of seasonal or even daily factors. The other, "forced" cycles, that are imposed by external forces such as misallocation of capital, supply and demand imbalances, and excessive use of leverage. Free cycles tend to return to equilibrium but forced ones may not. Not all forced imbalances are of equal concern. Some simply lead to recessions -- whether mild or deep -- while others are more problematic, requiring substantial intervention to return to equilibrium. Fisher compares most recessions to the effects of a storm on a ship at sea. The winds may be strong and may toss the ship about, but it's natural buoyancy will still tend to keep it righted. It's only when the winds become so strong that they send the ship to its tipping point, that it finally capsizes. Once capsized, it can no longer right itself and intervention is necessary. This is a distinct second difference from Keynes who encouraged a more active governmental role in smoothing economic imbalances. Based on observations drawn from the panic of 1873 and the Great Depression, Fisher postulated there can be a number of imbalances all working against the economy at once, but ...in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price-level disturbances. It is only when these two components co-exist, that a depression is a real possibility. In his words, "[I]f debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33." Just the presence of one without the other is generally not sufficient, either. Fisher believed the two must work together with the synergy of two diseases attacking at once. This is a third and major difference with traditional Keynesian doctrine which views all economic activity through the prism of aggregate supply and demand. Fisher offers the following chain of events that can lead to Debt-Deflation downward spirals: Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2)Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and their velocity, precipitated by distress selling, causes (3)A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) pessimism and loss of confidence, which in turn lead to (8)Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest. Doesn't that sound familiar? Isn't that a fairly accurate description of what happened with subprime loans, and over-speculation over the past two years? Don't get too tied down with the chronology, even Fisher admits the process isn't necessarily linear with many phases interacting at various times. The point here is, these are precisely the elements driving the current crisis.
Fisher's Solution Like Keynes, Fisher believed government intervention is necessary, because "it would be as silly and immoral to 'let nature take her course' as for a physician to neglect a case of pneumonia." Without such assistance, there is a major risk of "general bankruptcies of mortgage guarantee companies, savings banks, life insurance companies, railways, municipalities, and states." That's particularly chilling in regard to what's happened with Freddie Mac and Fannie Mae, IndyMac, Washington Mutual, AIG, and California.
Fisher believed that in such a crisis, "the question of controlling the price level assumes a new importance" and the Federal Reserve Board and the Secretary of the Treasury are responsible for taking action. Once again there's a remarkable parallel to his analysis and what's transpired in Washington over the past two years. Yet there's a fourth, and striking difference, between Fisher's recommendations and those of Keynes: Fisher looked to monetary policy alone to provide the solution. Keynes, on the other hand, taught that government spending could boost aggregate demand and in essence, help spend our way out of recession. His reflation worked through demand while Fisher's doesn't. Congress and the Obama administration have fully embraced the Keynesian approach. The President's stimulus bill does everything Keynes said it should. It provides money for everything from government sponsored infrastructure to green energy projects. It puts money in the hands of consumers through direct payments, tax credits, Medicaid, and unemployment extensions. It even includes some nice income redistribution through tax credits payable to those who don't pay any taxes. It sends money to the states to be used for similar purposes. Money goes just about everywhere except the source of the problem, the cash-starved credit markets. In order for the current approach to work, the lucky recipients of the government's largesse must go back into the marketplace, spend their windfall and increase demand for domestically made products. (Hence the flap over the "Buy American" enticements built into the stimulus bill.) The hope here is that the country can spend its way out of recession. Fisher focuses on the Fed's role rather than pork barrel fiscal spending. His goal is maintaining a steady price level, exactly what the Fed is always supposed to do. "In fact," Fisher wrote, "under President Hoover, recovery was apparently well started by the Federal Reserve open-market purchases, which revived prices and business from May to September 1932 [but] the efforts were not kept up" under Roosevelt. Interestingly, minutes form the January FOMC meeting indicated the Fed was actively discussing similar open market activity. (It should be noted that Fisher also favored government price controls, citing the success at the time in Sweden. The Nixon administrations misadventures in that regard should eliminate that option from serious consideration.) The key point here is that Fisher's "refflation" is more than just spending money; it's targeting the spending to bring "the price level back up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors." In the current situation, that would most directly apply to the housing market where the problem originated.
Targeted Spending One could therefore argue that reflationary efforts should focus on stabilizing and possibly bringing housing prices back toward their pre-bubble levels. The President's stimulus package certainly wasn't directed this way. The Obama administration is said to be considering some sort of bailout package for struggling homeowners, but even this if not structured to stabilize housing prices may still miss the mark. It's not clear at this writing what the administration has in mind, but several ideas that it has floated won't do the trick. One suggestion is to have the government offer assistance to homeowners on the brink of foreclosure. This may temporarily keep them in their houses and slow the rate of foreclosures, but won't directly help stabilize prices. A second idea is to allow the government (or bankruptcy judges) restate mortgage loan terms by reducing the amount of principal owed. This is a dreadful option on a number of levels. First, it would immediately devalue the value of the loan for any lender, whether it be an institution or individual investor. At the very least this would serve as a considerable chilling effect on the home loan market thus harming rather than helping the overall housing market. Secondly, cutting principal balances lowers the price level rather than restoring it; a clearly counterproductive effect. Here's an alternative to consider: The government (probably through its agencies Fannie Mae and Freddie Mac) could offer everyone -- whether they're on the verge of default or not -- the opportunity to refinance their mortgage at a fixed rate of say, 4%. Homeowners wishing to take advantage of this offer could do so by contacting their current mortgage holder to initiate the process. The government's role would be to subsidize the current loans in order to bring them down to 4%. This subsidy would help recapitalize the struggling lenders while making affordable loans available to all. The government wouldn't end up owning a pile of non-performing loans in a "bad bank", and its subsidies would be specifically targeted as opposed to the willy-nilly giveaways of Congress' two stimulus packages. The opportunity to reduce mortgage interest rates would go a long way to stemming the number of non-performing loans and foreclosures. It would help turn these troubled assets into performing loans on the lenders' balance sheets. By stabilizing the market, housing prices would have the opportunity to return to their fair values, cutting off Fisher's debt-deflation spiral. By doing it through private lenders, the ongoing role of government will be limited.
It's only fair that this offer be available to all mortgage holders whether they're behind on their payments or not. Everyone is struggling and eventually whatever the government spends will need to be repaid -- and everyone will be expected to participate in that endeavor through significantly higher taxes. There's no reason to make those who have managed to keep their debts current take on the additional burden of paying for those who knowingly over speculated. The 4% rate used in this example has been selected only for illustration purposes. There are plenty of government economists who could come up with the "right" value. Presumably this would be the result of balancing the number of loans that could be saved against the cost of the government subsidies as the rate falls. We'll leave that to the experts. Of course there's very little chance that a solution like this will be enacted. There's currently too much rhetoric against "subsidizing the predatory lenders' who are at least partially responsible for this mess in the first place. It's also not an income redistribution plan currently favored by the administration. Professor Fisher warned that had the leaders of his day refused or misdirected attempts to target spending to blunt the debt-deflationary spiral, "they would soon have ceased to be our rulers. For we would have insolvency in our national government itself." Let's hope today's leaders read a little Fisher along with their Keynes. Search this site! Just enter you key word or words:
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UANTITATIVE ANALYSIS DRAWS heavily from tendencies in the past. Theories are created, tested, and put in place based on factors that have proven (or at least are believed) to have influenced prior outcomes. So the natural thing to do when economic growth declines is to look back at prior slowdowns to see what caused them, how the overall economy reacted, and how expansion finally resumed. The problem with the current recession is that it isn't like those of the recent past.
