Four Horsemen of Financial Apocalypse

I am usually not inclined to indulge in religious iconography or prophecy as it is mostly noise from my point of view, but this one is too good to pass up. As the markets are ebullient these days, on the one hand I am grateful for my lucky star and on the other, I can't shake the jitters, I am still focused on the underlying issues and I have a hard time enjoying this bear rally.

Via VoxEU this morning an analysis of the DYNAMICS of the issues.

Four dangers
The first danger we have witnessed since August 2007: The subprime mortgage crisis gave rise to a liquidity crisis in the international banking system, due to uncertainty about who holds the losses. This is leading to reduced lending to firms and households. But that is not the end of the story, because the reduced lending will lead to reduced consumption and investment. With a lag, reduced sales of goods and services will reduce stock market valuations. And, with another lag, the lower stock market prices will – in the absence of any favourable fortuitous events – intensify the banks’ liquidity crisis.

The second danger lies in the dynamics of U.S. house prices. As more and more U.S. households find themselves unable to repay their mortgages, foreclosures are on the rise, more houses are put on the market, the price of houses falls further – with further lags – this leads to more foreclosures and declines in housing wealth. This dynamic process plays itself out only gradually, as households face progressively more stringent credit conditions and house sales gradually lead to lower house prices.

The third danger results from the interaction between wealth, spending and employment. As U.S. households’ wealth – in the housing market and the stock market – falls, their consumption is beginning to fall and will continue to do so, again with a lag. This decline in consumption is leading to a decline in profits, of which more is on the way, which in turn will lead to a decline in investment. The combined decline in consumption and investment spending will eventually lead to a decline in employment, as firms begin to recognise that their labour is insufficiently utilised. The decline in employment, in turn, means a drop in labour income, which, with a lag, leads to a further drop in consumption.

And that leaves the fourth (and possibly the nastiest) of the dangers, one that concerns the latitude for monetary policy intervention. As the Fed reduces interest rates to combat the crisis, the dollar is falling. This is leading to higher import prices and oil prices in the United States, putting upward pressure on inflation. The greater this inflationary pressure – which is currently in excess of 4 percent – the more difficult it will be for the Fed to reduce interest rates in the future, without running a serious risk of inflaming inflationary expectations and starting a wage-price spiral. U.S. firms and households will gradually recognise this dilemma and the bleak prospect of little future interest rate relief will further dampen consumption and investment spending.

I really have 2 comments to make.

1- What the article really identifies are the feedback loops in the system in the variables of "liquidity, house prices, consumers". I have talked about non-linear dynamics in the past. Remember that self feeding loops lead to non-linear behavior and are the basis for complex system dynamics. The problem with these systems is that the output is non-deterministic and the language used can only be probabilistic. Think quantum physics. In this instance the author gives extra attention to the TIME-SCALES, although he doesn't quantify them. It is not enough to know what variables are involved and how they interact, knowing the DYNAMICS of the interaction is really key to understanding the probabilities. The best parallel I have found in science is in the system biology field. It is a hard science but really permeated with the understanding that you are dealing with the living. Far from being a dismal science, I would characterize economics as "living sciences", closer to biology than math. In biology, the study of timescales of interaction is key to modeling the steady states of cells. In solid state physics, studying the phase transitions leads to usually highly dynamic equations. Another way to read the article above is to say that we are now WITNESSING such a transition and it happens on a monthly/yearly timescale, while the day to day observation of markets may shield the underlying trend in noise. But the trends are there.

2- Limits of the FED action. That one I am not so convinced by. The gist of the argument is that the FED field of action is increasingly limited. The FED is running into a wall. The FED will soon start being counter productive by stocking inflation fears as it cuts interest rates. The point is interesting and well taken. Already yesterday's FED cut sent the markets on a rocky up and down because they signaled END of easing cycle. However, the FED is really doing monetary policy not only with the rates but also by taking on assets that are impaired as they are doing so through the various lending facilities. Remember that the FED has committed $400B of T-Bills in swap for many securities (see Dead mice collateral in this blog). It has another $400 it could commit to that, BEFORE really actually running the printing presses. I have argued in the past that the FED essentially has ONE MORE bullet in its arsenal to stabilize markets without running inflation. And then it can really start the presses. In other words, the market is flush with FED liquidity at the moment, there is plenty more where that came from, and its nature is not necessarily inflationary. I have also not read a modern analysis of inflation as a function of M2. I have read everywhere that "inflation is ALWAYS a monetary phenomenon" but nowadays, with the more elastic offer, how does price react to an increase in demand on elastic goods? Not all goods are elastic (see commodities) but many are, no? I still believe in the power of the FED to get us out of this predicament.