Wednesday, January 28, 2009

Banking led recessions and Deflation

The real subtitle is "a failure to nationalize the banking system, if needed, will lead to the second great depression"

I have been mulling over the little fact, shown in Rogoff's paper, that equity recovery lagged economic recovery in banking led recessions in general and more particularly in the Great Depression. I have also been following the growing confusion in the inflation vs deflation debate.

I have been a deflationista since the beginning, even during last years oil spike because "inflation is always and everywhere a monetary phenomenon". If inflation is always and everywhere a monetary phenomenon then so is deflation. By monetary levels I mean M3+Debt, total money supply must include debt levels. Meaning FED money + bank leverage both regulated and unregulated (and here is where it all went poof). Unregulated debt equals unregulated money supply, and the invisible hand was just been mainlining lines of debt coke after lines of debt coke until it overdosed. There is a case to be made that the last 10 years of "prosperity" were largely fueled by money supply and velocity, not real economic value.

So the question, mathematically, simply becomes one of balance, can the FED replace enough debt to offset the drop in private debt and stabilize prices? The FED's first role is price stability. But the Fed can print all the money they want, if that money is not circulating, its velocity is zero and its anti-deflationary impact is zero. In that case, getting the banks to lend again requires nationalization. Plus it would make sure we avoid the, improbable, scenario of hyper-velocity post recession leading to hyper inflation.

Banking led recessions are nasty, as opposed to industry cyclical ones, because they affect monetary levels, both supply and velocity, they are external factors to any industry. This impacts the "real economy" over a period of 1-2 years. We are starting to see this hit wall street earnings. Those who think that the banking system can collapse disorderly without impact, are akin to people looking at a nuclear flash and thinking "oh it is just over there". Wait for the physical wave, it's coming and it is the second wave that destroys everything. A disorderly (too rapid, chaotic, random) collapse will trigger the second great depression just as sure as a disorderly liquidation of banks plunged the US and the world in the first one.

Until the banks get back on their feet, which means until the housing situation is sorted out, there is no way OUT of the current recession, period. The FED cannot spend its way out fast enough. Roubini talks about USD 4T in the banks alone. Again in that case swift nationalization of the banking system is the only way. If the banks, structurally cannot fulfill the socially necessary lender role then it must be nationalized and the government must assume the role of lender of last resort and distribute through existing skeletons of banks. This is monetary keynes, if there is such a thing.

And finally there is the link to the equities lagging economic recovery that i was looking for. In banking led recessions equities lag economy precisely because it is banking led and the usual leverage doesn't apply. Also the gold standard was in place. So equity recovery was purely a function of economic recovery, not one of monetary levels. In this current fiat case, one may make the case that Dow 8000, and stable, is a sign of partial success of QE and a sign that they are printing money fast enough to avoid the disorderly liquidation of the banking system.

But triage it needs and triage there will be. That triage is either orderly by itself, or we need to nationalize swiftly. A disorderly collapse will trigger the second great depression by continuing the downward spiral of depressed money levels both supply and velocity which will result in massive deflation.

10 comments:

Army No Va said...

Yep...+1...

Here is an interesting view...we experienced this wave (albeit a bit shallower) in Texas 20 years ago except the last phase (cash buyers) because the NY and NC banks bought the TX banks and kept lending (at 20% down payment requirements).

This time, the Fed is the only one really able to do this.

http://www.oftwominds.com/blogjan09/endgame-RE01-09.html?ref=patrick.net

Roy Russo said...

My bet... you won't see this level of nationalization until the second wave hits. We're notorious for ignoring problems that stare us in the face, until something blows up; be it from a rat in a cave in Afghanistan or drunken lending policies at Freddie/Fannie.

For now, I sit on cash and McDonalds, because everyone knows that a Big Mac can survive a nook-u-ler blast.

Marcf said...

Pierre, interesting link. This banking led recession is housing led and will finish with housing. Hopefully the banking system won't completely collapse in the meantime, but it is clear that losses are not over.

Roy: ROTFLOL

Army No Va said...

Roy, I thought it was guns and alcohol! You can get all the Big Macs you want if you have guns (and well placed friends)!! :-) ...

Obama will nationalize the mortgage system, at least, by Summer 2010 or earlier. Or he'll force them to lend at whatever rates and downpayments necessary to slow the housing bust. Actually, it's the only way to avoid the last leg which overshoots to the downside on those charts in that article I posted a link to.

If he freezes foreclosures...all bets are off. That will be uncharted territory (well maybe we get a view from our Eastern European and Russian collegaues what universal govt housing is).

Maybe that young woman on the famous YouTube video at Grant Park celebrating Obama's win gets it more than I do...Obama WILL help her with her mortgage and gas!

I better get that Ron Paul sign down and put an Obama sign up in the yard :-) ...

Bill Burke said...

Didn't somebody post the other day here that there are a lot of smaller healthy banks around lending to qualified buyers. Is there any way to funnel money to these smaller healthy banks so that they can grow quicker and meet the lending needs instead of throwing money at these large mismanaged banks that just seem to funnel bailout money for dividends and bonuses?

Marcf said...

Bill: Soros was talking about that yesterday at Davos. Basically he was saying that the 'bad bank' plan was flawed and he would rather see a 'good bank' plan along the lines of what you see.

Army No Va said...

Problem isn't that you can't get money if you have good credit. I can get a mortgage at Wachovia. I can get one at a small bank here in Atlanta. But, the problem is that even current real estate asking prices still are based on the availability of zero or low down to lower FICO score people. This type of leanding has disappeared. Which means many of the buyers have been eliminated from the market. Worse, as the foreclosures mount, even more potential buyers are being taken out of the market due to credit score hits. That's why heavily discounted foreclosures are making up more of the market, esp in bubble and over built markets as they are going to investors or bottom seekers that have plenty of choices and are going with the "best buys". And many of them are still overpriced. 120x monthly rent is a stable long term price for most suburban homes. But we'll need to get to 80x monthly rent in this market in many locales to clear the inventory, much of which will have to go to investors that will run a positive cash flow on it.

The small banks won't do the funny money / ridiculous LTV and debt/income ratios many potential buyers need to buy. Shoveling more money to the small banks won't change that. They do want to stay healthy and must keep many of these loans on their books (esp if they are Jumbo loans).

Bottom line...not enough buyers given the huge vacant supply, prices must and will fall.

Marcf said...

Pierre, always the optimist with housing aren't you.

I was amused by this comment:
"cleared by investors that will run positive cash flows on (houses)". That has got to be the biggest LOL today. I always thought equity was equal to discounted cash flow sum, so that cash flows needed to be positive for investors to get in. Another way of saying this of course is rent>mortgage by at least the risk free rate. If mortgage is 6 then rent has got to be at least 9% of price. A $350k house must bring $32k/year or 2,8k/mo. Of course the bubble economics throw the fundamental of equity pricing (cash flow sum) out of the window in a ponzi scheme of appreciation only supported by stupidity.

Army No Va said...

I am an optimist (esp if you will be a buyer!) ...I'm saying house prices will return to values based on fundmentals!

Yes, cash flow as you describe. 120x monthly rent in a solid area is a typical valuation that would yield what you describe. There are few houses (and there are some, but not many relative to the inventory/stock) that justify much of any premium over that.

In this economy, we will see 80x monthly rent for many (saw that in Texas in 1990 in a GOOD economy!). And even lower prices for houses that have ridiculous home owner assoc fees, assessments, insurance, or property tax. War / gang zones, I dunno...

I serched Detroit a little while ago on Realty.com and found 512 pages of houses for sale at $20K and below. You can find variations of this in Toledo, Buffalo, Cleveland, Gary, etc... How many more cities or exurbs will grow their under $20K inventory in this ecomony?!?

Marcf said...

Pierre, btw the link you posted is great. A must read.