The Myth of the Slow Crash

[Finster]

Question For EJ

Question For EJ

In another thread, (Fed Cuts Discount Rate - Post 15), you stated:

The 1987 type event I warned July 25 is coming does not happen until the market participants lose confidence in the ability of central banks to control events. Typically this happens some time after several of the kinds of Fed interventions that we saw today in a 50 basis point discount rate cut. If a major revelation follows soon after, then market participants start to wonder if there is a bottom at all. That's when the shit really hits the fan. Now there's still hope, and as long as their is hope there will be high volatility but no 1,000+ crash days. But those days are coming.

Later you commented in the opening post above as follows:

…

The lesson the Fed learned from the Japanese experience is: once debt deflation forces are in play, don't delay cutting rates. In a credit contraction, disinflation can get away from you quickly, driving up real rates of interest and shutting down the money creation machinery. Keep inflation above zero at all costs.
…
The paradox is that to prevent the recession that can develop into a run-away debt deflation, the Fed needs to cut early and often, but to avoid crashing the bond market and dollar, the Fed has to wait until it sees the whites of bond and currency traders' eyes. Timing, wording, and execution will be critical. And the bond market might get it wrong, too.
…

My question is whether your comments here relate to alternative scenarios or the same one. That is, do you foresee that this 1987'-type event comes even if the Fed does indeed "cut early and often"? The first quote forecasts that the Fed intervenes aggressively, it "hits the fan" anyway, hope is lost, and the stock market crashes. The second quote urges the Fed to intervene aggressively, suggesting that by such action dire consequences might be avoided. Does the second comment modify the first, or merely contemplate that 1987' still happens but that even greater consequences would be averted by aggressive Fed easing?

[Rajiv]

Re: Question For EJ

Question For EJ
. Does the second comment modify the first, or merely contemplate that 1987' still happens but that even greater consequences would be averted by aggressive Fed easing?

I am not EJ, but my impression on reading the entire thread was that it appears that the Fed is between the proverbial "Rock and a Hard Place" and the question really is whether it can find any cracks to squeeze though -- and that is yet to be determined. If I look at Hudson's theories, and also look at the state of leveraged debt -- I do not see any way out other than stagflation.

[c1ue]

Re: The Myth of the Slow Crash

Welcome back C1ue.

Lukester,

Did you miss me? Or did my admitting to buying a big pile of GLD put me on your posse? ;)

[c1ue]

Re: The Myth of the Slow Crash

My question is whether your comments here relate to alternative scenarios or the same one. That is, do you foresee that this 1987'-type event comes even if the Fed does indeed "cut early and often"? The first quote forecasts that the Fed intervenes aggressively, it "hits the fan" anyway, hope is lost, and the stock market crashes. The second quote urges the Fed to intervene aggressively, suggesting that by such action dire consequences might be avoided. Does the second comment modify the first, or merely contemplate that 1987' still happens but that even greater consequences would be averted by aggressive Fed easing?

Finster,

I can't speak for EJ, but it seems to me that the statements are pretty clear:

1) The worst won't come until the Fed (and all other 'saviors') lose credibility. At this point I think only the Fed has it; the government does not, nor do the banks/hedgies/PE etc.

2) The Fed knows it must cut early and often; dragging this out just results in Post-Japan

3) However, unlike Japan the Fed does not have the economic luxury of doing so. The US being a debtor nation and also with an unsound economy would be crushed if the dollar were then punished and US inflation/interest rates rose as a consequence.

The point - which I am perhaps completely off base on - is that the Fed does not have a safe path to proceed on to get out of this mess.

Thus unless Bernanke and Co. pull a Nobel Prize in Financial Engineering out of of their collective ivory throne seats, we're all in the pot.

The most likely outcome is thus a series of timid moves - none of which betray the Fed's weakness - all of which don't do squat in the market.

This will then be followed by the 'what the heck, we might as well cut anyway' capitulation which will do no good.

Then all heck breaks loose!

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[Finster]

Re: The Myth of the Slow Crash

I am not EJ, but my impression on reading the entire thread was that it appears that the Fed is between the proverbial "Rock and a Hard Place" and the question really is whether it can find any cracks to squeeze though -- and that is yet to be determined. If I look at Hudson's theories, and also look at the state of leveraged debt -- I do not see any way out other than stagflation.

Finster,

I can't speak for EJ, but it seems to me that the statements are pretty clear:

1) The worst won't come until the Fed (and all other 'saviors') lose credibility. At this point I think only the Fed has it; the government does not, nor do the banks/hedgies/PE etc.

2) The Fed knows it must cut early and often; dragging this out just results in Post-Japan

3) However, unlike Japan the Fed does not have the economic luxury of doing so. The US being a debtor nation and also with an unsound economy would be crushed if the dollar were then punished and US inflation/interest rates rose as a consequence.

The point - which I am perhaps completely off base on - is that the Fed does not have a safe path to proceed on to get out of this mess.

Thus unless Bernanke and Co. pull a Nobel Prize in Financial Engineering out of of their collective ivory throne seats, we're all in the pot.

The most likely outcome is thus a series of timid moves - none of which betray the Fed's weakness - all of which don't do squat in the market.

This will then be followed by the 'what the heck, we might as well cut anyway' capitulation which will do no good.

Then all heck breaks loose!
…
:eek:

Thanks, guys. I pretty much got that. Guess it was my question that wasn’t so clear. I was trying to get clarification on whether his call for the 1987' event is altered by whether the Fed follows his prescription for aggressive easing.

[Rajiv]

Re: The Myth of the Slow Crash

Here is what happened in Agentina -- that is not what I am suggesting will happen here, but the Argentinian case is worth reexamining.

From Argentina 2002

"Don't Cry For Me Argentina" (from Andrew Lloyd Webber's Evita) was a big hit song around the world in the late 1970s. This year the world is lamenting Argentina's economic woes. The country is currently on course to set a record for the largest number of people to lose the most wealth in the shortest period of time. Argentina is surely an economy to cry for.

Unemployment in Argentina has climbed to 25%. The real GDP is projected to decline this year by approximately 10-15%, the largest single-year decline on record and following three consecutive years of recession that began in 1999. After nearly a decade of relatively stable prices, inflation is currently in triple digits. In April the IMF tentatively estimated that prices would increase by 30% or more this year. However, month-to-month prices jumped by 10% in April alone. If prices were to continue to escalate at that monthly rate for twelve consecutive months, then the annual rate of inflation would exceed 200%! Currency markets have already factored in April's inflation rate, and the floating peso has fallen to about $0.27 from the 1 peso = 1 dollar parity that Argentina managed to fix throughout most of the 1990s. Argentina's MERVAL stock market index has declined by nearly 75% since the end of last year. Measures of macroeconomic activity for a semi-industrialised economy rich in natural and human resources don't get much worse than these.

Like the Great Depression of the 1930s, the stagflation of the 1970s, and the economic implosion of the former Soviet Union in the 1990s, Argentina's economic collapse should remind us all of how fragile economic systems really are and how important it is to have sound economic institutions in place and effectual corrective policy on stand-by when things start to go wrong. The consequences of a dire economic performance have devastating and long lasting negative psychological effects on those persons who suffer and endure the hard times. Individual confidence is shattered, and hope is overwhelmed by despair. Fear and uncertainty paralyze the economy. Practical solutions get lost in a deluge of ideological polemic while the economy continues to flounder. Years, if not decades, of economic stagnation can pass by before confidence, stability and growth are eventually restored. This, it would appear, is Argentina's fate.
.
.
It was in 1999 that Argentina's economy turned "bad." Real GDP fell by 3.4%. Unemployment began to rise. Stock prices began to fall. Hopes for a quick recovery were dashed when the economy declined by nearly 1% again in 2000. The year 2001 was even worse when the economy recorded another 3.7% decline in real GDP. By this time, Argentina had become bogged down in an "L" shaped recession. There are several explanations for Argentina's downward slide. Most explanations focus on a series of adverse external shocks including a decline in international commodity prices, the rising cost of of capital for emerging market economies, the Brazilian real devaluation, an overvalued peso pegged to an appreciating US dollar, and higher interest rates caused by a restrictive monetary policy in the United States. Argentina's currency board system and commitment to a fixed exchange rate made it virtually impossible for monetary authorities to respond to these shocks.

This is where the proverbial rock and a hard place comes for the US. US is in a similar bind to Argentina. I don't think the "Helicopter Trick" will work -- Too much of the manufacturing infrastructure has been off-shored - and it will take a generation to rebuild.

My guess is that the situation will be similar to Argentina - but with very few options left until the infrastructure can be rebuilt. The big question in this will be -- can the US shift to a low volume oil economy while doing it - relying only on North American Petroleum resources. I am assuming that Mexican and Canadian economies are too intertwined with the US economy to be separable. If Canada or Mexico bailout, things will be extremely tough!

[Rajiv]

Re: Question For EJ

state of leveraged debt

See Rating Agencies : The Monopoly Of The "three Usa Sisters"

[jk]

Re: The Myth of the Slow Crash

it is no longer as clear to me as it once was that cutting rates will tank the dollar. the ecb has backed off its hawkish stance as sarkozy et al are crying out about the difficulties of living with a strong euro. japanese rates remain very low, and the chinese are taking their own sweet time in allowing the renminbi to rise. coordinated cuts by cbs around the globe might be in store. all currencies will decline together against real goods, and the dollar might not look particularly bad, relatively to other fiat currencies. gold would do well in this scenario.

[jimmygu3]

Bernanke on helicopters, price indexes

Coming off the housing bubble, the Fed is worried about the US experiencing a flavor of runaway debt deflation such as Japan suffered after their real estate bubble collapsed starting in 1992. Preparedness for that eventuality was the gist of Bernanke's now famous helicopter money speech in November 2002, two and a half years before the housing bubble peaked.

I must admit, I just read the full text of that speech, and I would encourage anyone who hasn't to do so. In context, the helicopter line is not such a big deal in my opinion. He's simply saying that a money-financed tax cut is a way to get dollars directly to Americans as an extreme method of combating deflation, provided that rate cuts are ineffective and rates are approaching zero. What's so bad about that?




What I was a bit shocked to read was Bernanke's footnote regarding inflation measurements and price indexes.

6. Several studies have concluded that the measured rate of inflation overstates the "true" rate of inflation, because of several biases in standard price indexes that are difficult to eliminate in practice. The upward bias in the measurement of true inflation is another reason to aim for a measured inflation rate above zero.

Does he really think the rigged CPI overstates inflation?!? What are these "studies" to which he refers?

Jimmy

[zoog]

Rate cut seems likely

As well prepared as the Fed appears to be theoretically to handle the current crisis, helicopters and all, the conditions for applying the cure this time for this purpose are far more challenging than in 2001 and 2002 when they were conceived. ... The paradox is that to prevent the recession that can develop into a run-away debt deflation, the Fed needs to cut early and often, but to avoid crashing the bond market and dollar, the Fed has to wait until it sees the whites of bond and currency traders' eyes. Timing, wording, and execution will be critical. And the bond market might get it wrong, too. ... When, not if, the US goes into recession in Q4 this year as unemployment begins to rise, the housing market will take its next and more serious turn down. As inflation falls toward negative rates the Fed will cut drastically. But if they wait that long, the Japanese experience is that the moves will then be too late.

According to a Marketwatch report, it sounds like a rate cut in September is likely.

Most of the economists at Jackson Hole believe that a rate cut by the Fed is a foregone conclusion unless there is a dramatic turnaround in the economy before the Federal Open Market Committee meeting on Sept. 18.

Influential economist Martin Feldstein told the Jackson Hole forum that the Federal Open Market Committee should lower the federal funds rate by as much as a percentage point.Hatzius of Goldman Sachs said that his expectations of a rate cut later this month "were cemented" by Friday's speech by Fed Chairman Ben Bernanke. He would not rule out a half a percentage-point cut in September.

...

In effect, Mussa said, Bernanke "has promised a rate cut on Sept. 18 unless the problems in the credit market miraculously disappear." ...

Mickey Levy, chief economist at Bank of America Corp. ... "I am virtually certain [the Fed] will ease on Sept. 18," Levy said, adding that the move would be enough to keep the economy from going into recession.

...

Overall, Hatzius has forecast three-quarters of a percentage point in rate cuts by the end of 2007.

They are also talking about recession being increasingly likely...

Hatzius agreed there was a "significant risk" of recession, putting the odds at one in three.

...

Gramley, the former Fed governor, said that the odds of a recession are somewhere between 33% to 50%. "This is a severe problem which will have to be dealt with," he said.

Furthermore, as I believe EJ and others have surmised, the Fed may be ill-prepared to handle the current situation.

David Hale, an economist and a regular at the Jackson Hole conference, called the current environment "a crisis of information."

...

The hard data on the impact of the credit crunch and market turmoil on the U.S. economy is also a few months away. The third quarter was almost half over when the crisis erupted.


Economists at BNP Paribas wrote in a research note that it "will be months" before the impact shows up in unemployment data.


The tightening of financial markets is likely to have a negative impact on GDP, especially in the fourth quarter. Fourth-quarter GDP data won't be released until January 2008.


In the meantime, Fed officials "will have to play it by ear," said Michael Mussa, formerly chief economist for the International Monetary Fund.

[GRG55]

Re: The Myth of the Slow Crash

...My guess is that the situation will be similar to Argentina - but with very few options left until the infrastructure can be rebuilt. The big question in this will be -- can the US shift to a low volume oil economy while doing it - relying only on North American Petroleum resources. I am assuming that Mexican and Canadian economies are too intertwined with the US economy to be separable. If Canada or Mexico bailout, things will be extremely tough!

By dint of shared history, and geography, Canada has a high dependence on US markets that long pre-dates NAFTA. Canada is unable to insulate itself from the side effects of US economic contractions. The vocal minority of Canadians that advocate Canada restrict energy exports, if necessary, fail to recognize it would only greatly compound the damage. These are the same people that would hoard the food on a desert island for themselves, letting all others starve. They end up well fed. And alone.

I interpret the (heavily criticised) tripartite SPP initiative as recognition of this reality at the highest political levels.

[GRG55]

Re: The Myth of the Slow Crash

Thanks, guys. I pretty much got that. Guess it was my question that wasn’t so clear. I was trying to get clarification on whether his call for the 1987' event is altered by whether the Fed follows his prescription for aggressive easing.

Good question. Look forward to EJ's clarification.

One thought: Bernanke's Jackson Hole speech included "The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets."

Seems the Fed still views their responsibility as "standing by ready to clean up the mess". If so, isn't any pre-emptive Funds rate cut (before a significant equity market decline) inconsistent, and therefore unlikely? :confused:

[jk]

Re: The Myth of the Slow Crash

Good question. Look forward to EJ's clarification.

One thought: Bernanke's Jackson Hole speech included "The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets."

Seems the Fed still views their responsibility as "standing by ready to clean up the mess". If so, isn't any pre-emptive Funds rate cut (before a significant equity market decline) inconsistent, and therefore unlikely? :confused:

it's not inconsistent if they think someone's already made a mess.

[Rajiv]

Re: The Myth of the Slow Crash

To me that would result in a worldwide stagflationary trend -- one that cannot be sustained - because an exponetial rise in currency supply at some time becomes impossible to accomplish

[zoog]

Re: Bernanke on helicopters, price indexes

What I was a bit shocked to read was Bernanke's footnote regarding inflation measurements and price indexes.

6. Several studies have concluded that the measured rate of inflation overstates the "true" rate of inflation, because of several biases in standard price indexes that are difficult to eliminate in practice. The upward bias in the measurement of true inflation is another reason to aim for a measured inflation rate above zero.

Does he really think the rigged CPI understates inflation?!? What are these "studies" to which he refers?

Jimmy

I think you meant to say "Does he really think the rigged CPI overstates inflation?"

Probably the Boskin Commission report in 1996. Greenspan was claiming the CPI overstated inflation by around 1% back in 1994. So Bernanke is just repeating the party line. The Boskin recommendations resulted in further tampering with the CPI calculations, skewing them even further from reality, which is, of course, higher inflation than reported. I'm sure Bart could give you a more detailed answer.;)