Pushing on a String

One of the biggest problems in trying to resuscitate a broken financial system and an economy like ours that appears poised for much more than a garden-variety downturn is the limited impact that traditional policy tools can have.

It's all well and good for everyone to bet on -- and cheer for -- the Fed to keep waving its magic monetary wand and then hope that everything will be better in the morning. But what happens if and when all that cheap credit isn't having any real effect?

In "US Slides into Dangerous 1930s 'Liquidity Trap'," The Daily Telegraph's Ambrose Evans-Pritchard details interesting insights from Joseph Stiglitz, one of the few economists whose head doesn't seem to be in the clouds these days, on what could be a very unsettling development.

The United States is sliding towards a dangerous 1930s-style "liquidity trap" that cannot easily be stopped by drastic cuts in interest rates, Nobel economist Joseph Stiglitz has warned.

"The biggest fear is that long-term bond rates won't come down in line with short-term rates. We'll have the reverse of what we've seen in recent years, and that is what is frightening the markets," he told the Daily Telegraph, while trudging through ice and snow in Davos.

"The mechanism of monetary policy is ineffective in these circumstances. I'm not saying it won't work at all: it will help the banking system but the credit squeeze is going to go on because nobody trusts anybody else. The Fed is pushing on a string," he said.

The grim comments came as markets continued to suffer wild gyrations, reacting to every sign of contagion spreading to Europe, Asia, and emerging markets.

Wall Street has begun to stabilize on talk of a rescue for the embattled bond insurers, MBIA and Ambac.

The Fed's 75 basis point rate cut allows the banks to replenish their balance sheet by borrowing at short-term rates and lending longer term, playing the credit 'carry trade', hence the 9pc rise in the US financials index yesterday. But confidence remains fragile.

Professor Stiglitz, former chair of the White House Council of Economic Advisers, said it takes far too long for monetary policy to work its magic. This will not gain much traction in the midst of a housing crash.

"People have been drawing home equity out of the houses at a rate of $700bn or $800bn a year. It's been a huge boost to consumption, but that game is now up. House prices are going to continue falling, and lower rates won't stop that this point," he said.

"As a Keynesian, I'd say the biggest back for the buck in terms of immediate stimulus would be unemployment assistance and tax rebates for the poor. That will feed through quickly, but set against the magnitude of the problem, even a fiscal stimulus package of $150bn is not going to be enough," he said

"The distress is going to be very severe. Around 2m people have lost all their savings," he did.

NASDAQ president Bob Greifeld expressed a rare note of optimism at the World Economic Forum, predicting a swift rally as the double effects of the monetary and fiscal boost lift spirits.

"I think the stimulus package that's been proposed by the President, to the extent that this is passed in rapid fashion by Congress, has the ability to forestall a recession," he said.

"At the moment, our business is doing better than it ever has because the volumes have been incredibly high. So, it's been very good for us," he said.

There were scattered signs of improvement across the world today, with Germany's IFO confidence index defying expectations with a slight rise in January. Japan's quarterly export volume held up better than expected.

Even so, the global downturn may already have acquired an unstoppable momentum, requiring months or even years to purge the excesses from the bubble.

Professor Stiglitz blamed the whole US economic establishment for failing to regulate the housing and credit markets adequately, allowing huge imbalances to build up.

"The Federal Reserve and the Bush Administration didn't want to hear anything about these problems. The Fed has finally got around to closing the stable door (on subprime lending), but the after the horse has already bolted," he said.

Comments

[mw]

Some time in the future, if we have another massive drop in the markets, and rates are 1/2% what will the Fed do (and what will Larry Kudlow say) The "gun" will be empty ( or with one dud shell).... WHAT THEN?.... THINK JAPAN.

[Edward Charles Ponzi Jr.]

So we are a debtor nation and a nation of debtors. That makes unravelling rather difficult – any serious deflation would make banks, Wall St and homeowners insolvent. How the battle between a sinking economy and an activist Fed – trying to re-flate – plays out is an interesting exercise. One possible outcome is massive price inflation – as money sometimes goes where you don't want it to go.

Michael -- as you know *THE* debate in the Doom Enthusiast Community is if the FED can create enough monetary aggregates to levitate asset and consumer prices. In the 1930s we did not need to import so much or spend so much -- hard to compare -- the Powers That Be had different issues also.

We all know what B-52 BEN has said:

http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm

The question is: will the inflation bomb go pfffft..???? Or can the FED really overpower everyone and everything with net positive inflation???

[Thomas Shawn]

""As a Keynesian, I'd say the biggest back for the buck in terms of immediate stimulus would be unemployment assistance and tax rebates for the poor."

Thinly veiled Marxism. Pay people to be unemployed and take tax money from the rich and give it to people who pay no taxes.

[BenBittrolff]

Bottom Line: The average Joe six pack is a baby boomer quickly running out of time. His single largest asset, his primary residence, is deflating rapidly. This single largest asset is also the primary collateral for his single largest liability. His balance sheet is rapidly deflating as all his assets, from his home to his equity portfolio, all simultaneously deflate while his debt outstanding may actually still be increasing. His debt servicing are costs not dropping, despite aggressive rate cuts, and may actually be rising. It has also become damn near impossible to refinance certain mortgages as easy credit evaporates. On top of that, Joe six pack should now be seriously concerned about his job security. So when a cheque for $300 to $1500 arrives in the mail, Joe six pack is not going to spend it on a $200 steak dinner or a new computer or on a vacation. Got it people?

More on the stimulous package: (http://benbittrolff.blogspot.com/2008/01/fact-sheet-bush-stimulous-package.html)

TheFinancialNinja

[flow5]

Everybody flunked accounting:
Commercial Banks as a system don’t loan out anything. They create money when they make loans
Money creation is not self-regulating
You can’t take money out of the banking system (only the FED can)
Savings transferred through the intermediaries never leaves the CB system. The intermediaries/non-banks are the customers of the CBs.
Savings held within the commercial banking system are lost to investment or to any other type of expenditure.
From the standpoint of the economy the banks shouldn’t pay for something they already have. Payments on CB savings raise all interest rates, induce disintermediation among the financial intermediaries, shrink real-gdp, & decrease CB profits.
The proper long-term solution to our non-bank problem is to get the money creating depository institutions out of the savings business. Then long-term rates would come down.