What’s going on with the economy?

Paul Krugman runs through some basic scenarios.  Remember when Philip Cagan asked why open market operations are performed in terms of money and T-Bills rather than other assets?

The final whammy may be this: the socialist calculation debate (remember that?) is now working against rather than for recovery.  Market prices communicate vital information but that assumes a critical mass of market participants is actually trading.  When trading dries up, prices go away.  When prices go away, the costs of trading rise and fewer people wish to trade.

Felix Salmon notes:

My feeling is that the credit markets are hysterical. They’re
not clearing, they’re not acting efficiently, and spreads, especially
on highly-rated debt, are much higher than credit risk alone could ever
account for.

Trading in junk bonds hasn’t been "right" since the fall.  Many of the markets for short-term debt securities are becoming illiquid as well.  Why markets are self-destructing in this way remains a puzzle; dump on markets all you want but why here and now?

Loyal MR readers will know that I am usually an economic optimist but at the moment I am worried.  I don’t see the so-called "real side" of the economy as intolerable by any means.  But a weird financial dynamic seems to be feeding on itself in an unusually violent fashion.  Steve Waldman has an insightful albeit overstated argument; consider this:

The distinction between debt and equity is much murkier than many
people like to believe. Arguably, debt whose timely repayment cannot be
enforced should be viewed as equity. (Financial statement analysts
perform this sort of reclassification all the time in order to try to
tease the true condition of firms out of accounting statements.) If you
think, as I do, that the Fed would not force repayment as long as doing
so would create hardship for important borrowers, then perhaps these
"term loans" are best viewed not as debt, but as very cheap preferred

Is/was the subprime crisis simply a mask for a more general revaluation of the meaning and extent of liquidity?  Are such revaluations always so bumpy and so lacking in locally stable iterative processes?  As the Chinese would say, we live in interesting times.


Krugman cites Steve Randy Waldman's Interfluidity blog. In an earlier blog posting of his, Waldman makes a distinction between a panic and a reckoning. Bailouts won't help if we are facing a reckoning.

Similiar, Nouriel Roubini has often made the distinction between a mere liquidity crisis and a solvency crisis.

The system is losing enormous amounts of liquidity. It is coming out of niches that make it very hard to replace through traditional monetary policy actions. The common thread is the withdrawal of liquidity from highly rated but non-transparent funding markets. These are not the subprime markets but were taken down by the collapse of subprime securities and the (justified) loss of reliance on the rating agencies.

1. The asset backed cp market is simply going away. This is taking $1T out of the banking system. The money fund assets that had been in this market are not being reinvested within the banking system, most is going into T-bills. This is an invisible bank run we have been living through since August.

2. Most providers of consumer and commercial credit have come to rely explicitly on securitization as their ultimate source of liquidity. There is practically no access to funds available in this market, and it is the highest rated end where the liquidity is worst. The banks weren't really capable of replacing these markets as a funding source even without their own funding crises to address.

To put this as simply as I can, the main providers of liquidity within the financial system -- money market investors and other providers of liquid cash -- are not built to take credit or liquidity risk. Yet the system developed such that they were, through extendible ABCP, auction rate notes, etc, all backed non-transparently by instruments with all kinds of credit risk and liquidity that was chancy in the best of times. Now that this risk is evident, all these investors can do at this time is to withdraw from the markets. They do not have the financial or operational structures to do otherwise.

So right now there is no liquidity for credit risk securities. The only way to lay off risk is through credit indices like ABX, CDX, CMBX, which are completely irrationally priced at this point. And as a corollary to the point you note of debt turning to equity - this means that these debts must now be capitalized like equity, in terms of leverage and expected return. Until they can be restructured into debt with highly certain performance, the sources of funds to support them will remain insufficient.

This is not an easy problem to solve, and most proposed ideas seem ridiculous on their face. Market participants are more and more just looking for some sort of deus ex machina to bail them out. And losing sleep over it, even on Saturday nights now.

Dan is right on -- the fed is majorly screwing the pooch. There was a real mis-pricing of in the markets, based on the incorrect assuption that default risks were much lower than they actually were. The fed cannot paper over that mistake, nor is it the fed's job to find the the correct prices -- only large-scale market experimentation can do that. It is the fed's job to keep inflation under control, and the fed could do it, but it is busy doing exactly the opposite in a doomded-to-failure attempt to paper over a real market correction that must occur. Where is Paul Volcker when we need him?

James Heckman's recent paper on high school graduation rates implies something that has gotten papered over -- America's median human capital, which grew tremendously for the first 70 years of the 20th Century, has been stagnating for decades. According to Heckman, the high school dropout rate, for example, hit a low of 20% around 1969, and is now up to about 25%.

We're becoming a less middle class country, but the government lured ever more people into buying their own homes, despite declining average human capital below the upper middle class.

And now there's a reckoning.

tyler, you should reread lombard street.

bagheot's description of banking panics in the 1800's uk looks a lot as to what is happening.

on the other hand, the scale and magnitude now is so much vaster that 1) it is order of magnitudes more scary as hell 2) one wonders is difference of scale translates now into different in kind and all we've learned about credit seizures is not as useful or perhaps even useless.

Politics and Economics are having a head-on collision RIGHT NOW... keep an eye on Mr. Krugman's articles as you watch the collapse. Will we even make it to an election come November? Keep in mind that George Bush has the power to invoke martial law at any time...

Forget the Chinese, how about, "a fool and his money are soon parted." That pretty much sums up what's happening now. The banks weren't careful about who they lent their money to and now they're broke. Doesn't matter how low the fed sets rates, banks have to stick that money in reserve to cover their prior foolishness.

The markets seem to be working just fine. Everyone expects it will be hard to get credit, the banks will have a hard time, and that people who gave banks money (were buying their weird financial instruments) will go broke. (Of course I live in South Florida and "everyone" here is a little jaded when it comes to banks.)
P. S. Some economists should try reading the Calculated Risk blog sometimes. They would be less suprised.

Check out Karl Denninger at Market Ticker. He's been sounding the alarm since April '07.


Can someone who knows more about this explain (or give a link) whether this TAF scheme can actually avoid causing inflation?

What's wrong with our economy? Well apart from the natural business (and life) cycle of ups and downs, I see our lack of PRODUCTION as a real problem.

We are too dependent on consumption of imported goods and do not produce enough "things" for domestic consumption (and export), which keeps money here in our country. Why is this? Because our elites in DC and New York are not really American patroits anymore, they are true internationalists/globalists, who feel compelled to raise the standard of living of every 3rd worlder around the globe.

We need vast tax cuts for businesses to specifically pursue greater production (engineering, manufacturing, high tech, etc.) within our borders (do we have borders anymore, amigo?)

Perhaps Keynes and Milto Friedman are right. The Keynes notion that a liquidity trap can prevent markets from correcting and you need fiscal stimulus to spur such an economy. Never was a fan of the theory before but I didn't go through the great depression. And for those on the other side Milton Friedman might warn of trying to apply economic Darwinism to markets. One of the things that contributed to the great depression, according to Milton Friedman, was just letting banks fail. The resulting bank runs should have been forseen and prevented with minimal initial interventions.

DanC, what do you think of this idea that we've done the whole Iraq war on forward borrowing, rather than from current tax receipts?

DanC...the liquidity trap is nonsense. If the interest rate is low, then the lenders will not lend. People will try to avoid holding bonds, they will try to sell them...which causes bond prices to fall and interest rates to rise. What prevents interest rates from rising? Central banks, because of the stupid idea that low interest rates 'stimulate' economy. 'Liquidity trap' is simply a problem that is created by central bank and disappears in the moment when central bank stops 'stimulating'(or destroying?) economy.

Keynes and his followers simply had the stupid idea that 'not enough money' is the cause of our problems. This is a classical 'fallacy of aggregation' - what is true for individual is not necessarily true for a society. If an individual is illiquid, he has a problem of 'not enough money' that can be solved by borrowing from somebody who 'has enough money'. Unfortunately, this doesn't mean that if there is nobody with 'enough money' that the problem can be cost-less solved by printing money. When half of the economy is illiquid, the costs involved with printing money gets so visible, that even the post-Keynessian/monetarist economist at the Fed can see that printing money is NOT a solution to 'not enough money' problem - new money simply translates to inflation and solves absolutely nothing.

Misplaced's seems the key comment above. And this is an international crisis, though U.S. (fiscal and monetary) policy, as Steve Sailer points out, surely played a role in encouraging U.S. hhs to overborrow. But I suspect going forward we will find that gov't for good or ill is less powerful than we think.

Here's a question. Some set of assets is gonna get a U.S. gov't bailout. We seem on course to make explicit the implicit guarantee for agency securities. Some banks will need rescuing, maybe big ones. What else?

"generations" Dan? That seems a long time to wait before paying this back.

What exactly does it cost to borrow a trillion dollars in gov debt? And how many median households does it take to cover that interest?

(I think it is harsh enough that returning soldiers will be taxed for it at their new jobs, and that we enjoyed tax cuts in their absence.)


Does this not mean that people were not as exposed to risk as was feared? That is that the sellers of what is supposed to be distressed assets were only exposed at the margin. So they can ride this out for some time; if the reckoning comes it will come gradually or not at all. At some point buyers will stop waiting and put their money into assets. Put another way, if this sub-prime contagion/recession talk is a "panic," generated by the collapse of a tiny part of a vast world economy, a few discouraging statistics, and bad press eager to ruin the GOP, only a fool would sell. When the panic is gradually over, trades will recur. The only thing I'd sell now is gold and oil.


I don't want to defend Keynes, but it appears that housing prices can be sticky and may be very slow to respond on the downside. This the Keynes story. Interest rates are dropping but lenders don't seem to have a desire to lend and consumers lack the desire or ability to increase borrowing. Consumers do not yet see good investment opportunities in housing.

Keynes would then argue for fiscal stimulus. Of course giving the government a free hand is a potential problem in the long run. But you seem to argue that there is no multiplier effect from government expenditures. And at this point, government spending in the housing market is unlikely to have any crowding out.

The question is, can low interest rates and a weak dollar increase domestic production without being swamped by an increase in imported commodities.

Word to mouse! This crisis isn't going away until players in the debt markets are convinced that ratings actually mean something. The markets (and/or regulators) are going to have to work out more reliable methods to assess default risk. The fed lending all the money in the world at subsidized rates isn't going to make that magically happen.

DanC, I have never really understood the idea behind "fiscal" or "monetary" stimulus. The idea behind these stimuli is that there are no costs associated with printing money and that economy is somehow affected symmetrically.
You may have have sticky overvalued prices in housing. But: the government is doing everything they can not to let the housing prices to fall. How can you expect the prices not to be slow to respond in such environment?
Second: you may have overvalued prices in housing, but you have undervalued prices in other sectors. You may expect inflation to counter the problem in housing, however how can you expect there won't be any negative effects in the other sectors? Remember: the last monetary stimulus caused the housing bubble. How do you expect the next one not to cause another one?
No, there is absolutely no multiplier effect from government expenditure. The whole Keynes theory simply doesn't work.

This recession has the potential to be the most severe in a long time. The multiplier effect on banks, who are very leveraged, may have a huge negative impact on the economy. Combined with high oil prices, increasing food prices, and the threat of much higher taxes if the Democrats are elected, our future may hold a decade of little or no growth.

How do you take the weight off the banking sector? You could let them go bankrupt or force them into a very conservative shell. The desire of some here to see them suffer because after all they created the mess is self destructive. The Federal government may need to resort to depression era housing sector bailouts. The tax revenues needed to fund such a program pales when compared to the lost economic growth for a decade or the resulting chaos of bank failures.

The moral hazard is small, I think the markets have learned the dangers of subprime lending, and I hope the Federal regulations that encourage high risk loans are revisited. But taking these bad loans off the books may be required

The notion that what this economy needs is a good stiff tax increase is a terrible idea. I would agree that we need simplification of the tax code and a reduction in regulation. We do not need to increase taxes on group X because it plays well in the polls or because it fits your notion of equality, we need to grow the economy and prevent a potential disaster. And make no mistake that we could repeat the Japan mistake and lose a decade of potential prosperity.

And by your comments, do you assume that in addition to immediate troop withdrawals from Iraq, will Hillary or Obama also cut all economic aid to the area so that they can achieve your goal of reduced "war" expenditures.

I certainly did not say the economy needed "a good stiff tax increase."

I simply object the implication that future administrations will raise taxes just just because they like 'em.

You've got a long-term mess, and possibly a short-term necessity to add to the mess.

At some point someone will have to pay for it. I think it's a Hail Mary play to think that "simplification" & etc. will give you that for free (let alone "less regulation").

(Your comments about Iraq might also be grouped as "mess clean-up.)

Andy said: I have never really understood the idea behind "fiscal" or "monetary" stimulus.

Do you know the difference between the two.?????????

First, what is the big advantage of a balanced budget? Why is a budget unbalanced? You are either spending too much or taxing too little. So is the government spending for good projects, in which case borrowing to fund these projects are really investments in the future. If the spending is wasteful, stop spending.

Using the tax code to do social engineering is potentially destructive. If Congress is unable to raise the money they need, they just place regulatory and distorting tax incentives as a back door to greater government control. And when did I claim that tax cuts increase revenues? I think tax simplification, which the Democrats hate and Republicans on occasion mention, will most effectively raise the required revenues without so distorting the market that you help feed things like the subprime loan mess.

For example, Obama and to a lesser degree Hillary want to attack the automotive industry and saddle them with a big increase in CAFE standards. Beating up large corporations plays well in Democratic circles. A more honest, less market distorting approach, would be to impose a carbon tax and let the market find the most effective way to meet the changes. But instead Obama gives speeches about how he is going after the auto industry because that will lower the price of gasoline. But why is he making this claim, because it plays well to the audience. Does it make sense? Not really. But you may be his target market.

We are coming close to a cliff with this economy. The most serious downturn in 50 years is possible. I fear that

The argument I've heard Dan is that, if you don't want things to get away from you, you spend at deficit when the economy is weak, and repay that debt when the economy is strong. If I've got my "beginning" and "end" right that means you spend at deficit at the beginning of business cycles (to aid recovery and expansion) and repay that debt at the end (perhaps in part to prevent overheating).

If you try to expand forever, I'm told, it tends to hit the fan.

As an aside, I believe that the CAFE mileage (the actual measure of mileage in the fleet sold) has always exceeded the CAFE requirement (the mandate). That is, Congress has never been so aggressive that they force people beyond the choices they are already making. A wikipedia graph seems to show this (the blue line is above the red line), but you can also just look at today's news. We (weakly) require future SUVs to get better MPG, but people are already fleeing from SUVs.

andy, try reading this.


andy: I dont see a net stimulus, its all based off demand side junk thinking. Just like Bush 2001.

Bush 2003 however, was supply side and is the main reason we had the bull market till last fall.

High taxes are THE problem. And do you agree that taxes are going up. In 2010 for sure, and maybe even in 2009 if the right(no pun intended) people win in Nov.

So we have a environment of Bernanke inflation and tax increases coming, you bullish.?????

andy said:russ... high taxes are THE problem.

Lowering taxes and borrowing the money changes one problem into another one, probably equal.

Lowering spending would change the situation,

however I was told in another discussion on this blog that 'lower taxes + lower spending' is not called 'fiscal stimulus'... unfortunately,

because that is the only thing that would actually work.

andy said: But the higher interest rates because of government borrowing will have roughly the same effect as taxation, don't you think so?

No, I dont agree. If you look at interest rates in the 80's they declined as the deficit increased,as the deficit got bigger interest rates declined. It is really a stretch to equate high interest rates with taxation. The facts do not support the crowding out effect idea.

Gov borrowing is NOT the same as printing money. The treasury borrows money, the Fed prints it. Inflation is always and only a monetary phenomenon, to quote Milton.
Borrowing money does not cause inflation.
If the unit of account were stable, interest rates would rise and fall due to credit conditions.

It is Mr.Bernankes job to supply just the right amount of new money to answer what the market wants, in order to keep prices stable, something which he has failed to do.

But again you verve away from the relation of taxation to economic growth, and go off on a monetary tangent.

Why does it have to?

If someone in the third world wants $1000 US dollars, they have to sell us $1000 worth of goods and services to acquire it, that means we must run a $1000 deficit with them. It goes with the turf.
Britain had the same problem in the 1800's when the pound was the currency in demand.

BTW, Hillary and Obama both scream about ending tax breaks that encourage the movement of jobs out of the country. First, I wish they would name a company that did this. Second, why don't they mention that high tax burdens and regulatory interference do more to push jobs out of the country then their straw man.

The economy went out of recession when Fed lowered the rates and started printing more money.

No the economy went out of recession when the Reagan tax cuts kicked in.

You have interest rates on the brain, your whole world revolves around interest rates, how sad.

oops, the last one was written by me :)


what do you think of this.


andy said:
What is the difference NOW? Absolutely nothing - the deficit has exactly the same result as taxes. What is the difference in the future? Financing the government with bonds almost guarantees higher taxes in the future.

No, there you error if the tax cut increases economic growth, taxes will be lower in the future because the economy will be bigger.

andy said:
From you article: "In addition, the cost of financing the debt soared with the highest interest rates in U.S. history."

Still no problem? They DID think it was a problem...

The problem was solved by the 1982 Reagan tax cuts which increased the DEMAND for dollars, which in turn sopped up the excess liquidity previously created.

andy said:
You would surely expect interest rates to fall when Fed started printing money.

Really, you believe that, you see no inflation premium in interest rates.

andy sai:
Ahead of which game? That's like saying that if you increased taxes, you come ahead of the game if the economy is fast enough to grow.

That does not make sense, I think you are losing it in that last paragraph. you seem to be very confused as to the nature of interest rates, you might want to read Mises, Human Action.

The game is economic growth, and increasing taxes does not create economic growth, but decreasing taxes will.

Comments for this post are closed