Interview with Paul Kasriel

[EJ]

Interview with Paul Kasriel
December 12, 2006 (Mish's Global Economic Trend Analysis)

Mish: Would you say that consumer debt in the US as opposed to the lack of consumer debt in Japan increases the deflationary pressures on the US economy?
Kasriel: Yes, absolutely. The latest figures that I have show that banks' exposure to the mortgage market is at 62% of their total earnings assets, an all time high. If a prolonged housing bust ensues, banks could be in big trouble.

Mish: What if Bernanke cuts interest rates to 1 percent?
Kasriel: In a sustained housing bust that causes banks to take a big hit to their capital it simply will not matter. This is essentially what happened recently in Japan and also in the US during the great depression.

AntiSpin: Two colleagues in the business that I respect, Mish and Paul, believe the current asset bubbles will end in monetary deflation. As iTulip readers know, I have been in the iTulip "Ka-Poom Theory" disinflation/inflation camp since 1999, and executed a profitable trade against it in 2000 and 2001–sold stocks before the end of the stock market bubble in Q1 and Q2 2000, stayed in cash and Treasury securities until the disinflationary part of that Ka-Poom cycle ended, then bought precious metals in Q3 2001 when I perceived a bottom in the disinflationary part of the cycle. Can lightening strike twice?

Mish and Paul believe, as you can see from the interview, that the housing bust now in progress may push the U.S. into a Japan 1990 - 2006 or U.S. 1930s style "deflation." The argument is that the Fed can cut interest rates but it won't matter. The Fed will experience the monetary "pushing on a string" problem because the Fed can't force banks to lend or households to borrow, and as 2/3 of the U.S. economy depends on consumer spending, a deflationary recession–what used to be called a depression–may ensue.

I believe that the collapse of the housing bubble, along with the end of the speculative parties in 8,000 "hedge funds" (USIPs) and emerging markets, will unleash powerful deflationary forces, but that the Fed and global central banks are prepared to deal with the event. The Fed has been clear about the range of measures it is willing to take, and have demonstrated a willingness to take them, such as allowing the housing bubble to occur following the collapse of the stock market bubble.

Bernanke has indicated that the Fed can "buy across the yield curve," and print money to buy debt and assets that are currently restricted, such as mortgages. The Fed has long argued that if the Bank of Japan were willing to do this, they could end their "deflation" quickly. Many forget that in fact the BoJ purchased stocks on the Japanese stock market directly to support the market in the 1990s, then slowly and quietly sold them later. They had to do this because so many Japanese banks held stocks as reserves against loans, and a self reinforcing cycle of falling reserves, declining loans, and falling stocks was crippling the Japanese financial system. U.S. banks do not use equities as bank reserves, but there is nothing to keep the Fed from purchasing bank reserve assets directly with printed money. In fact, they have stated that if needed, that is precisely what they will do. I expect we'll see a period of disinflation as after the end of the stock market bubble, but with varied characteristics because of the difference between a collapsing stock and housing bubbles–fast and shallow versus slow and broad. The Fed will watch the rate of inflation and keep interest rates below the rate of inflation. The well recognized mistake that the Fed made in 1930s and that the BoJ made in the 1990s is that the central banks allowed inflation to fall below zero; as the Fed cannot lower rates below zero (actually, they can and central banks in other countries in the past have done that, effectively paying borrowers to borrow money, but that's a discussion for another day), the Fed was left powerless (at least in theory) to take an accommodative (inflationary) interest rate stance. The Fed did not make that mistake in 2001, and will not make again in 2007-2008.

Only time will settle the argument, but Mish and I spoke yesterday and decided that our readers will enjoy watching the two of us get in the ring with a moderator to duke it out–in friendly way–in a podcast. We will record it tomorrow and published it on both Mish's site and iTulip shortly thereafter. Stay tuned here for an announcement or sign up for iTulip Alerts to be notified when the podcast becomes available.

[akrowne]

Re: Interview with Paul Kasriel

Here is a re-post of what I posted in response to Mish regarding the possibility of a Japanese-style deflation in the US:

---

I think you pose a provocative question, Mish, with the comparison to Japan. Yes, I think deflation as the long-term outcome in the US is possible. Do I think it will happen? No.

I believe the main reason Japan's deflation has been so long-lived is because of a confluence of a number of specific factors:

1. The ZIRP and high liquidity in general
2. Sclerotic business environment in Japan
3. No capital controls
4. Higher interest rates, more dynamic economies/markets elsewhere (notably the US)

These all result in the use of Japan almost exclusively for leveraged carry trades in the global financial economy. That is Japan's most significant role. It is, actually, pretty pathetic, as Japan hasn't benefitted at all in the past decade from all their efforts. They've simply become an instrument of hedge funds.

The only reason they don't reverse their policies (at the foundation, the ZIRP), is for fear of crashing global financial markets (remember what happened in May? That was an experiment). So they're stuck.

Now, it is of paramount importance to note something regarding Japan: they have been applying large-scale liquidity/stimulus policies this whole time. But because of the other factors listed above, the liquidity has largely ended up outside of Japan.

Let's translate this to the US. Could it ever find itself in such a bizarre position -- an overwhelmingly stimulatory liquidity policy, but no domestic inflation? For this to be the case, you must agree that:

1. The US continues massively inflating the dollar monetary base
2. Almost none of the money ends up in the US
3. There must be ample (huge) foreign capital markets to invest in
4. There must be a long-term interest-rate differential between the US (low) and these other markets (high)
5. The US must maintain the above policies despite the obvious result that they aren't working for domestic stimulus.

Some of these seem likely to be the case. #1 is all but inevitable, if only for paying off the deficit spending, personal and corporate bailouts, and entitlements. But unless the US is dumb enough to enact a ZIRP and keep it there despite total failure over decade-long timescales, and unless there's almost no reason to invest in the US and there are ample, compelling foreign markets to invest in (perhaps Europe or China?), the same situation will not repeat.

There are other differences: the US has the world's reserve currency, and Japan didn't (doesn't); the US is by far the most import-dependent, etc. The inflationary risk posed by the latter is obvious. The impact of the former is more difficult: but what I do know is that Japan has opted for currency stability by defending the Yen, which has required accumulating lots of poorly-performing dollar bonds and other securities in an official capacity. What would US do if the situation was reversed, given that it would have no other single reserve currency to accumulate in? The Euro bond system is nowhere near as unified, mature, or liquid.

I think the US will just have to defend the dollar, and keep interest rates high, potentially even leading the rest of the world up in interest rates. This will be staflationary.

I conclude that any period of deflation/disinflation will be very brief in the US. It simply requires too many serendipitous factors to have both high liquidity policies and low inflation in the long term.

[jk]

Re: Interview with Paul Kasriel

The Fed will watch the rate of inflation and not allow interest rates to fall below the rate of inflation, the mistake that the Fed made in 1930s, the BoJ made in the 1990s, but the Fed did not make again in 2001, and will not make again in 2007-2008.

don't you mean "not allow interest rates to be higher than inflation"? or "not allow inflation to fall below interest rates"?

[FRED]

Re: Interview with Paul Kasriel

[/B]don't you mean "not allow interest rates to be higher than inflation"? or "not allow inflation to fall below interest rates"?

JK, clarified above. Makes more sense?

[blazespinnaker]

Re: Interview with Paul Kasriel

The Fed will experience the monetary "pushing on a string" problem because the Fed can't force banks to lend or households to borrow, and as 2/3 of the U.S. economy depends on consumer spending, a deflationary recession–what used to be called a depression–may ensue.

Disagree. Deflation will not happen because the fed can't do anything about it. The fed can throw money out of helicopters. Deflation will occur (if it does) because the fed believes it's the best thing for the economy.

[lewman]

Re: Interview with Paul Kasriel

akrowne,
if I hadn't misunderstood you, you think the FED will have to keep interest rate high. In doing so, would it not potentially push the economy into a recession and high interest rates also reduces lending and we have Japan's deflation situaion (monetary deflation) ?
lewman

[Charles Mackay]

Re: Interview with Paul Kasriel

Disagree. Deflation will not happen because the fed can't do anything about it. The fed can throw money out of helicopters. Deflation will occur (if it does) because the fed believes it's the best thing for the economy.

No one here can say for sure that Blazespinnaker couldn't possibly be right. Bottom line is that the elites will do whatever is necessary to protect their own status quo, the Federal Reserve System, and their own wealth. If deflation serves that purpose so be it. Is there anyone here who thinks the Fed, large interests on Wall Street, and the banks couldn't cause a deflationary depression in the next 24 hours if they wanted to? Sure they could.

In a hyperinflation the entire landscape of government and social institutions changes... the FED is probably elminated once and for all. Probably not what they want. It's instructive to remember the recent history of 1980 when we almost lost the US dollar. Did the FED inflate? No, they raised interest rates to 20% in order to save their asses.

Can anyone find out whether Paulson's approx. $1 billion net worth is in gold or treasuries? Then we'd know.

[jk]

Re: Interview with Paul Kasriel

Mish and Paul believe, as you can see from the interview, that the housing bust now in progress may push the U.S. into a Japan 1990 - 2006 or U.S. 1930s style "deflation." The argument is that the Fed can cut interest rates but it won't matter. The Fed will experience the monetary "pushing on a string" problem because the Fed can't force banks to lend or households to borrow, and as 2/3 of the U.S. economy depends on consumer spending, a deflationary recession–what used to be called a depression–may ensue.

i think that when the fed starts to loosen we will have another "conundrum." the prior one was that long rates stayed low even as the fed raised short rates. this was at least partially a response to the currency appreciating in 2005. when the fed starts to ease, the dollar's slide will be reinforced, which will pressure the treasury market. so we will have the "conundrum" of lower short rates but rising long rates. that will further pressure the housing market.

if,and only if,the fed moves out the yield curve to lower long rates will the housing decline be cushioned. but if they bring the 10yr low enough i, for one, will be refinancing and so will millions of others.

[Charles Mackay]

Re: Interview with Paul Kasriel

i think that when the fed starts to loosen we will have another "conundrum." the prior one was that long rates stayed low even as the fed raised short rates. this was at least partially a response to the currency appreciating in 2005. when the fed starts to ease, the dollar's slide will be reinforced, which will pressure the treasury market. so we will have the "conundrum" of lower short rates but rising long rates. that will further pressure the housing market.

if,and only if,the fed moves out the yield curve to lower long rates will the housing decline be cushioned. but if they bring the 10yr low enough i, for one, will be refinancing and so will millions of others.

jk, you are assuming the FED and the elites want more inflation (possibly leading to a US dollar collapse and hyperinflation) and as BlazeS has pointed out that is not a given that it's in their best interest. BUT, if that is what they want then your scenario above would be yet another way they could put helicopter money in people's pockets.

I find it interesting that in the last month both Paul Volker and Paulson have said we are overdue for an exogenous event.

[jk]

Re: Interview with Paul Kasriel

jk, you are assuming the FED and the elites want more inflation (possibly leading to a US dollar collapse and hyperinflation) and as BlazeS has pointed out that is not a given that it's in their best interest. BUT, if that is what they want then your scenario above would be yet another way they could put helicopter money in people's pockets.

I find it interesting that in the last month both Paul Volker and Paulson have said we are overdue for an exogenous event.

my point is that the fed won't be pushing on a string if they lower LONG rates.

re: what do the elites want? i would think the optimum scenario is a gradual decline of the dollar in both purchasing power and in terms of foreign currencies.

[Jim Nickerson]

Re: Interview with Paul Kasriel

my point is that the fed won't be pushing on a string if they lower LONG rates.

re: what do the elites want? i would think the optimum scenario is a gradual decline of the dollar in both purchasing power and in terms of foreign currencies.

So how does the fed control LONG rates?

[WDCRob]

Re: Interview with Paul Kasriel

Instead of trading in short-term notes on the open market they'll buy longer term treasuries to drive the prices up and interest rates down. JK's saying that if that happened it'd spur housing as people took advantage of lower rates again to refinance (since mortgage rates are driven by interest rates on the longer bonds).

Go back to one of EJ's columns where he quotes Bernake talking about the steps the Fed might take to prop up asset prices and prevent deflation. Longer bonds are just one option.

And apologies if I've got the language wrong here, Jim. Vocabulary follows after the logic takes hold, I'm afraid.

[Charles Mackay]

Re: Interview with Paul Kasriel

re: what do the elites want? i would think the optimum scenario is a gradual decline of the dollar in both purchasing power and in terms of foreign currencies.

jk, the wealth disparity between the elites and main street has gotten so skewd that only a fool would deny that whichever way the elites swing their bat is the way things are going to go. That being said, Jim Puplava and iTulip support the postition that the elites want to keep creating bubbles. That is the linear way of thinking. I lean in that direction also. But maybe it's prudent to ask the question why we lean in that direction? Recent history shows that they were willing to raise interest rates to 20% in order to save the dollar and kill gold. Isn't that proof enuf where their real interests lie? They will save their monopoly and kill main street before they allow dollar death and hyperinflation. There is no harm in entertaining this position and thinking it thru.

[jk]

Re: Interview with Paul Kasriel

jk, the wealth disparity between the elites and main street has gotten so skewd that only a fool would deny that whichever way the elites swing their bat is the way things are going to go. That being said, Jim Puplava and iTulip support the postition that the elites want to keep creating bubbles. That is the linear way of thinking. I lean in that direction also. But maybe it's prudent to ask the question why we lean in that direction? Recent history shows that they were willing to raise interest rates to 20% in order to save the dollar and kill gold. Isn't that proof enuf where their real interests lie? They will save their monopoly and kill main street before they allow dollar death and hyperinflation. There is no harm in entertaining this position and thinking it thru.

the episode to which you refer led to the deepest recession since the great depression. but a similar intervention now would likely far exceed that episode in its consequences. perhaps i am naive, but i assume that people who are doing very, very well will in general approve of the system in which they reside and act to preserve it. in 1979 or so, that required killing inflationary expectations, which had become institutionalized and self-reinforcing via cola's in labor contracts. the current era will require a different set of interventions to avoid a different set of dangers. the current dangers to the economic system reside in debt levels and unfunded governmental obligations. the only solution to THESE problems is a devalued dollar. a rapidly declining dollar would be destabilizing, so the solution is a slowly declining dollar. people with power will act to achieve that goal. and they will retain their power and their wealth.

[Charles Mackay]

Re: Interview with Paul Kasriel

the episode to which you refer led to the deepest recession since the great depression. but a similar intervention now would likely far exceed that episode in its consequences. perhaps i am naive, but i assume that people who are doing very, very well will in general approve of the system in which they reside and act to preserve it. in 1979 or so, that required killing inflationary expectations, which had become institutionalized and self-reinforcing via cola's in labor contracts. the current era will require a different set of interventions to avoid a different set of dangers. the current dangers to the economic system reside in debt levels and unfunded governmental obligations. the only solution to THESE problems is a devalued dollar. a rapidly declining dollar would be destabilizing, so the solution is a slowly declining dollar. people with power will act to achieve that goal. and they will retain their power and their wealth.

That's one way of looking at it. Or you could say that during the last episode where we had a runnaway gold bull market and a collapsing dollar (the 70's) the FED decided on a deflationary solution in order to surivive...rather than an inflationary one. And I agree with you, that solution today would put us in depression. If you have money there's nothing like a depression to scoop up assets and reduce labor costs.

Or, if you believe as Bob Chapman does that the elites goal is to create an Amero then that's another rationale for your position.

"People in the U.S. are going to be hit hard," Chapman warned. "In the severe recession we are entering now, Bush will argue that we have to form a North American Union to compete with the Euro."
"Creating the amero," Chapman explained, "will be presented to the American public as the administration's solution for dollar recovery. In the process of creating the amero, the Bush administration just abandons the dollar."