November 24, 2008
THE GREAT EXPERIMENT
Have we seen this movie before? It certainly sounds familiar.
Once again, the government steps in to bail out a financial institution and Mr. Market takes kindly to the idea. Initially. But then reality sets in and the process starts anew. Perhaps it'll be a true sign of a bottom when the Feds engineer a bailout and the market tanks on the news.
But not yet. The latest installment of rescue centers on the once mighty Citigroup. Meanwhile, the stock market is soaring, as is Citi's stock, as of mid-morning, at least.
A giant among giants, this behemoth of financial behemoths surely fits the bill as too big to fail. If such a thing exists as a financial institution that must be saved at any cost, Citigroup looks like the poster boy for this idea.
Total assets for Citigroup were a bit more than $2 trillion in September. For those who like to keep score, that's roughly 14% of the annualized value of U.S. GDP for this year's third quarter.
The days of pulling another Lehman and letting a big bank fail are history. Better to bailout more rather than less and deal with the consequences later. The grand strategy here is that if the government bails out enough banks (and perhaps an auto company or two) while spitting out stimulus in various forms as far as the eye can see, the system will correct itself, or at least stop bleeding. At a time when deflationary risks are rising, this plan is considered prudent and timely by a growing swath of economists and voices from the peanut gallery, including yours truly. The risk of an even deeper implosion of prices and confidence must be avoided lest the vortex of deflation pull everything down the rat hole. Preventing deflation is the last battle in this horror film because once the big "D" takes hold, in sentiment and prices, the challenge becomes much, much tougher.
The problem is that no one's really quite sure if deflation with a big "D" is on our doorstep. Quite possibly it is, or so one could reason after witnessing consumer and wholesale prices fall last month on a scale unmatched since the government began keeping tabs on such things in the late-1940s. Waiting for definitive signs risks letting the monster out of the cage. Decisions, decisions. Nonetheless, there's a strong case for assuming deflation is coming. If we're wrong, we'll have more inflation on our hands than we otherwise would. But the world knows how to fight inflation, even if the political will is sometimes lacking. Attacking deflation, on the other, is another story.
Any way you slice it, there's bound to be more than a little disappointment and finger pointing in the months and years ahead. Indeed, no one should think that the necessary but risky strategy of preventing deflation is destined to end in triumph, or quick results. The stakes are high, in part because the government's moving quickly toward betting the house on a fiscal/monetary solution. On the opposing shore is the unwinding of excess, some of which has been decades in the making. When an immovable force meets government printing presses, the outcome isn't entirely clear.
All the more so if the world is looking for signs, one way or the other, by next Wednesday. It's difficult to gauge expectations as we run from one crisis to another. But this much is clear: the financial and economic problems will take time--years--to solve, and to the extent that the crowd thinks otherwise, the seeds of disenchantment have been planted.
The U.S. economy is sick, and getting sicker. Europe has the disease and Asia is at risk of contracting the same, albeit in a milder form. Looking back on the past five decades offers no clue for what may be coming. Growth has been a constant, according to GDP numbers from economist Angus Maddison, emeritus professor, University of Groningen (Netherlands). As the chart below shows, outright contraction is unknown in the postwar era.
Fifty years is a long time, virtually an eternity for mere mortals studying the past in search of clues about the future. It's all too easy to look at this track record and conclude that real declines in global GDP aren't possible, or are so unlikely as to be unworthy of considering. The IMF forecast, for one, still imagines more of the same with next year's estimate for real global GDP rising by a respectable if not impressive 2.4%.
Of course, the crowd used to think in persistent-growth terms for housing prices, and how they never fall on a year-over-year basis. Oh, sure, that happened in the Great Depression, but such episodes were dismissed as a thing from the past.
Perhaps it's time to consider the unthinkable. We've all received a crash course in just that over the last few months. But has the education so far been sufficient? Or do we still need to spend more time studying?
There are many dangers stalking the global economy, and at the top of the list is the assumption that the governments of the world can spend their way out of the slump on our collective doorstep. In the U.S. alone, the government now stands at the ready to spend $7 trillion--yes trillion with a "t"--to bring financial salvation to the system, according to Bloomberg News. That's the equivalent of three-and-a-half Citigroups, or half the U.S. economy. Scale no longer looks to be a stumbling block.
By spending enough money, governments are likely to keep inflation-adjusted global GDP floating somewhere above zero, if only slightly. That would still bring a fair amount of pain and repricing, but embedded in the expectation is the notion that a floor can be built under the crisis.
Perhaps, although at some point one might wonder if the cure will be worse than the disease. There are some awkward questions that will accompany the mother of all spending sprees now underway. First up: Is there some point at which additional government spending becomes counterproductive because a) it encourages future inflation on a scale that will be excessively burdensome; and/or b) the prospect of the government owning ever-larger chunks of the economy risks institutionalizing mediocrity or worse in the economy?
There are two great episodes of deflation in modern history, and each continues to raise questions about the associated lessons. Yes, spending is the only hope of sidestepping the beast, and if that means artificially engineered demand from the government, so be it. But it's not clear that the strategy leads to happy results all around. Meantime, there's more than one way to fight deflation.
That's not to say we shouldn't try to spend our way out of a deflationary trap. We should. We must. And we will. The risk is real this time, unlike the previous worries over deflation in 2001-2003. But the details of how we engage our anti-deflationary war may matter as much, if not more, as the decision to wage the war in the first place.
The dismal science has precious little experience with fighting deflation and so we must recognize that we may soon be caught up in an economic experiment on a scale that has little or no precedent. By all means, let's fight this war ferociously. But it also needs to be fought intelligently. What exactly do we mean by "intelligently"? We can't say for sure. No one can, and therein lies the greatest risk.
Posted by jp at November 24, 2008 9:50 AM
That is in fact the current plan. The question is whether it'll be effective. There's more than a little uncertainty, in part because deflation is so rare and so there's not a lot of precedent for dealing with it in the real world. That won't stop the government from trying, but the outcome is to be determined.
Posted by: JP at November 26, 2008 12:10 PM
Not an economist here but can't help to think that if ever deflation is a problem , why doesn't the Fed let the money press run overtime to flood the market with money as to create inflation?
Obviously the dollar would weaken as a result but what would be wrong with this approach?
Posted by: Christian at November 24, 2008 4:07 PM