Radical Solutions For A Crazy Crisis
Nouriel Roubini
Forbes 11.27.08, 12:00 AM ET
The U.S. economy is confronting a toxic mixture: deflation, a liquidity trap and debt deflation, as well as rising household and corporate defaults. Put plainly, the signs of a "stag-deflation"--a deadly combination of stagnation/recession and deflation--are now clear.
We are in a severe recession, and now the recent readings of both the Producer Price Index and the Consumer Price Index show the beginning of deflation.
The slack in goods markets--with demand falling and supply being excessive (because of years of excessive over-investment in new capacity in China, Asia and emerging market economies)--means firms have lower pricing power and a need to cut prices to sell the burgeoning inventory of unsold goods.
The slack in labor markets means lower wage pressures and lower labor-cost pressures; and the slack in commodity markets--that have already fallen by 30% from their summer peaks and will fall another 20%-30% in a global recession--means lower inflation and actual deflationary forces.
The Risk of a Liquidity Trap
When deflation sets in, central banks need to worry about it--and worry about a liquidity trap. Take the example of the 2001 recession: That was a mild eight-month recession in the U.S. and was over by the end of 2001. But by 2002, the U.S. inflation rate had fallen toward 1%. The Fed was forced to cut the Fed Funds rate to 1% and Ben Bernanke (then a Fed Governor) was writing speeches titled "Deflation: Making Sure "It" Does Not Happen Here."
So if a mild recession that was not even global led to deflation worries, how severe could deflation be in a recession that even the IMF is now forecasting to be global in 2009?
When economies get close to deflation, central banks aggressively cut policy rates, but they are threatened by the liquidity trap that being zero-bound on nominal policy rates implies. The Fed is now effectively already in a liquidity trap: The target Fed Funds rate is still 1% but expected to be cut to 0.5% in December and down to 0% by early 2009. Also, while the target rate is still 1%, the effective Fed Funds rate has been trading close to 0.3% for several weeks now as the Fed has flooded money markets with massive liquidity injections. So we are effectively already close to the 0% constraint for the nominal policy rate.
Why should we worry about a liquidity trap? When policy rates are close to zero, money and interest-bearing short-term government bonds become effectively perfectly substitutable. (What is a zero-interest-rate bond? It is effectively like cash.) Monetary policy becomes ineffective in stimulating consumption, housing investment and capital expenditure by the corporate sector. You get stuck into a liquidity trap and more unorthodox monetary policy actions need to be undertaken.
The Costs and Dangers of Price Deflation
First, if aggregate demand falls sharply below aggregate supply, price deflation sets in. There is already massive price deflation in the U.S. in the sectors--housing, autos/motor vehicles and consumer durables--where the inventory of unsold goods is huge. The fall in prices and the excess inventory forces firms to cut back production and employment; the ensuing fall in incomes leads to further fall in demand--and induces another vicious cycle of falling prices and falling production/employment/income and demand.
Second, when there is deflation, there is no incentive to consume/spend today as prices will be lower tomorrow. Buying goods today is like catching a falling knife and there is an incentive to postpone spending until the future: Why buy a home or a car today if its price will fall another 15% and purchasing today would imply having one's equity in a home or a car wiped out in a matter of months? Better to postpone spending. But this postponing of spending exacerbates the vicious cycle of falling demand and supply/employment/income and prices.
Third, when there is deflation, real interest rates are high and rising in spite of the fact that nominal policy rates are zero. If the policy rate is zero and there is a 2% deflation, the real short-term policy rate is actually a positive 2% that further depresses consumption and investment; and real long-term market rates are even higher with deflation, as market rates at which firms and households borrow are much higher than short-term policy rates.
The Deadly Deeds of Debt Deflation
Deflation also leads to the nightmare of debt deflation, a situation well analyzed by Irving Fisher during the Great Depression. If debt liabilities are in nominal terms and at a fixed long-term interest rate, a reduction in the price level increases the real value of such nominal liabilities.
So debtors who are already distressed in a recession and deflation become even more distressed as the real burden of their liabilities sharply rises.
Things are even worse if the debtor had borrowed to finance the leverage purchase of assets whose prices are now falling. Suppose you are a household who borrowed at a 5% mortgage rate to purchase a home whose price is now falling at an annual rate of 15%. The effective real interest rate that you are facing on your debt is not 5% but a whopping 20% (the sum of the 5% mortgage rate plus the 15% fall in the price of the underlying asset).
In all of its manifestations, debt deflation sharply increases the risk that borrowers will be forced to default on real obligations that they cannot service. Thus, debt deflation is associated with a sharp rise in corporate and household defaults that create a spiral of deflation, debt deflation and defaults.
"Crazy" Monetary Policy to Address the Liquidity Trap and a Severe Liquidity and Credit Crunch
To address the increase in real short-term market rates, the Fed and other central banks have already undertaken quite unorthodox monetary policy moves. To address the even more severe increase in real long-term market rates, the Fed and other central banks will have to undertake even more radical and unorthodox policy actions.
The widening of the real short-term market rates has been addressed by creating a whole series of new liquidity facilities. Indeed, the Fed and other central banks that used to be the "lenders of last resort" have become the "lenders of first and only resort," as banks don't lend to each other, banks don't lend to non-bank financial institutions and financial institutions don't lend to the corporate and household sectors.
However, in spite of the Fed becoming the lender of first and only resort (even the corporate commercial paper market is now being propped by the new Fed facility), there are still major problems that remain seriously unresolved in short-term money markets and short-term credit markets.
Banks and other financial institutions are still not lending to each other in spite of lower spreads as they need the liquidity received by the Fed and they worry about the solvency of their counterparties; only banks and major broker dealers have access to these facilities and thus most of the shadow banking system does not have access to this Fed liquidity; market spreads are still rising and the availability of short-term credit is becoming tighter as banks increase interest rates on credit cards, student loans and auto loans and make such loans scarcer; only rated investment-grade firms have access to the commercial paper facility, leaving millions of speculative grade or non-rated firms in an even bigger liquidity and credit squeeze; and finally, the securitization of credit cards, auto loans and student loans is currently dead.
This is why a desperate Treasury is starting to think about using the remaining TARP funds to directly unclog the unsecured consumer debt market and the securitization of such debt. Desperate times required desperate and extreme actions.
Even "Crazier" Policy Actions are Required to Reduce Long-Term Market Interest Rates
But even more desperate monetary actions are needed to address the increase in real long-term market rates. These actions are needed to prevent deflation from setting in, to reduce the credit spread (the difference between long-term market rates and long-term government bond yields) and to reduce the yield-curve spread (the difference between long-term government bond yields and the policy rate).
There are a number of tools that the Fed could use to reduce the yield-curve spread when the Fed Funds rate is already down to zero. First, the Fed could commit to maintain the Fed Funds rate at zero for a long period of time. Even this, however, may not be sufficient to reduce long yields on safe assets as such long yields also depend on liquidity premiums and risk premiums that will not be affected by an expectation of future short rates. Greenspan discovered the "bond market conundrum," when raising the Fed Funds rate from 1% to 5.25% did not much change long rates; and Bernanke rediscovered this conundrum, when reducing the Fed Funds rate down to 1% failed to significantly reduce long rates.
Such long rates depend in part on the global supply of savings relative to the demand for investment; thus they are not likely to be strongly affected by current and future expected policy rates.
Second, the Fed could do what it last did in the 1950s: directly purchase long-term government bonds as a way of pushing downward their yield and thus reduce the yield-curve spread. But even such action may not be very successful in a world where such long rates depend as much as anything else on the global supply of savings relative to investment. Thus, even radical action such as outright Fed purchases of 10- or 30-year U.S. Treasury bonds may not work as much as desired.
Next, the Fed could try to directly affect the credit spread (the spread between long-term market rates and long-term government bond yields). Radical actions could take the form of: outright purchases of corporate bonds; outright purchases of mortgages and private and agency MBS as well as agency debt; and forcing Fannie and Freddie to vastly expand their portfolios by buying and/or guaranteeing more mortgages and bundles of mortgages. One could also decide to directly subsidize mortgages with fiscal resources. And the Fed (or Treasury) could even go as far as directly intervening in the stock market via direct purchases of equities as a way to boost falling equity prices.
Some of these policy actions seem extreme, but they were in the playbook that Gov. Bernanke described in his 2002 speech on how to avoid deflation. They all imply serious risks for the Fed and concerns about market manipulation. Such risks include the losses that the Fed could incur in purchasing long-term private securities, especially the high-yield junk bonds of distressed corporations. In the commercial paper fund, the Fed refused to purchase non-investment grade securities.
Even high-grade corporate bonds are not without risk as their spreads have massively widened in recent months. Also, pushing the insolvent Fannie and Freddie to take even more credit risk may be a reckless policy choice. And having a government trying to manipulate stock prices could create another whole new can of worms of conflicts and distortions.
Finally, the Fed could try to follow aggressive policies to attempt to prevent deflation from setting in: massive quantitative easing; flooding markets with unlimited unsterilized liquidity; talking down the value of the dollar; direct and massive intervention in the forex sphere to weaken the dollar; vast increases of the swap lines with foreign central banks aimed to prevent a strengthening of the dollar; attempts to target the price level or the inflation rate via aggressive preemptive monetization; or even a money-financed budget deficit (an idea suggested by Bernanke in 2002 that he termed to be the equivalent of a "helicopter drop" of money in the economy).
The problem with many of these "extreme" policy actions is that they were tried in Japan in the 1990s and the last few years, and they failed miserably. Once you are in a liquidity trap and there are fundamental deflationary forces in the economy as the excess aggregate supply of goods faces a falling aggregate demand, it is very hard--even with extreme policy actions--to prevent deflations from emerging.
Some very aggressive policy actions--such as letting the dollar weaken sharply--may do the job, but they may also be beggar-thy-neighbor policies that would export even more deflation to other countries. The world economy has been massively imbalanced for the last decade with the U.S. being the consumer of first and last resort, spending more than its income and running ever larger current account deficits while creating a massive excess productive capacity via over-investment.
All the while, China and other emerging markets have been the producers of first and last resort, spending less than their income and running ever larger current account surpluses. With U.S. spending now faltering, a global glut of unsold goods may lead to persistent and perverse deflationary forces that may last for a longer time unless proper policy actions--mostly non-necessary monetary--are undertaken.
Thus, dealing with this deadly combination of deflation, liquidity traps, debt deflation and defaults that I termed a global stag-deflation may be the biggest challenge that U.S. and global policy makers have to face in 2009.
It will not be easy to prevent this toxic vicious circle unless (1) the process of recapitalizing financial institutions via temporary partial nationalization is accelerated and performed in a consistent and credible way; (2) such actions are combined with massive fiscal stimulus to prop up aggregate demand while private demand is in free fall; (3) the debt burden of insolvent households is sharply reduced via outright large debt reduction (not cosmetic and ineffective "loan modifications"); and (4) even more unorthodox and radical monetary policy actions are undertaken to prevent pervasive deflation from setting in.
Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.
