Friday, April 17, 2009

IMF explicitly warns that it fears debt deflation - the hallmark, according to US economist Irving Fisher of the Great Depression’s economics

From Alphaville:

IMF: “worrisome parallels” with the Great Depression

The IMF has pre-released two chapters from its forthcoming World Economic Outlook.

Chapter 3: From recession to recovery: How soon and how strong?

Chapter 4: How linkages fuel the fire: The transmission of financial stress from advanced to emerging economies

The following excerpts rather put all the recent talk of green shoots into perspective. A few banking swallows do not a spring make. Quite the contrary. The IMF is now explicitly briefing of an economic catastrophe second, if not equal to, the Great Depression of 1929-33.

Emphasis ours.

The global economy is experiencing the deepest downturn in the post–World War II period, as the financial crisis rapidly spreads around the world. A large number of advanced economies have fallen into recession, and economies in the rest of the world have slowed abruptly. Global trade and financial flows are shrinking, while output and employment losses mount. Credit markets remain frozen as borrowers are engaged in a drawn-out deleveraging process and banks struggle to improve their financial health. Many aspects of the current crisis are new and unanticipated. Uniquely, the current disruption combines a financial crisis at the heart of the world’s largest economy with a global downturn.

… recessions associated with financial crises tend to be unusually severe and their recoveries typically slow. Similarly, globally synchronized recessions are often long and deep, and recoveries from these recessions are generally weak. Countercyclical monetary policy can help shorten recessions, but its effectiveness is limited in financial crises. By contrast, expansionary fiscal policy seems particularly effective in shortening recessions associated with financial crises and boosting recoveries. However, its effectiveness is a decreasing function of the level of public debt. These findings suggest the current recession is likely to be unusually long and severe and the recovery sluggish.

In fact, says the IMF, global downturns are typically one and a half times as long as typical recessions.

Most worrying though is the explicit comparison the IMF makes with the Great Depression - something even bearish commentators have skirted around so far for fear of being alarmist. The IMF lays it on the line:

A recession began in the United States in August 1929. A tightening of monetary policy during the previous year, aimed at stemming stock market speculation, is widely seen as the initial cause. The stock market crashed in October 1929, which prompted a sharp decline in consumption, partly because of increased uncertainty about future income.

The recession intensified and turned into a depression over the course of 1931–32. Pernicious feedback loops between the financial sector and the real economy emerged, leading to entrenched debt deflation and four waves of bank runs and failures between 1930 and 1933. Private consumption and investment contracted sharply.

and today:

Despite the differences in mechanics, the effects on the behavior of financial intermediaries are similar. Funding problems have led to balance sheet contraction (deleveraging), fire sales of assets (adding to downward pressure on prices), increased holdings of liquid assets, and decreased lending (or holdings of risky assets) as a share of total assets. Moreover, with today’s highly interconnected financial system, there has been gridlock because of network effects in a world of multiple trading and large gross positions. The ultimate effects of these financial factors on the real economy are similar in the two episodes.

The IMF explicitly warns that it fears debt deflation - the hallmark, according to US economist Irving Fisher of the Great Depression’s economics:

There is continued pressure on asset prices, lending remains constrained by financial sector deleveraging and widespread lack of confidence in financial intermediaries, financial shocks have affected real activity on a global scale , and inflation is decelerating rapidly and is likely to approach values close to zero in a number of countries. Moreover, declining activity is beginning to create feedback effects that affect the solvency of financial intermediaries, which risks of debt deflation have increased.

The IMF is clear: it really is all in the hands of the G20. The right policies will see recovery “in 2011″, the wrong ones… who knows.

I have used Fisher's model for the basis of my own views since the beginning of this crisis. Of his two possible solutions, reflation seems the sensible one, since a Debt-Deflationary Spiral has no natural stopping point. That's why it's terrifying. Arguing that we should let it play itself out is not on from my point of view.Consequently, reflation should have been much stronger than it has been.

Also, Lehman never should have been allowed to fail. Only an implicit or explicit government guarantee can stop a Calling Run, which began this crisis, because only governments have the resources available to credibly backstop the losses. Now, the point of the total guarantee is not to have to actually spend the money, but, rather, to allow the parties involved to more rationally and with with less loss unwind their deals. In this, the guarantees are like FDIC insurance to help stop Bank Runs.

We could have had a much less awful crisis with:
1) Large QE ( Buiter and Friedman's helicopter money )
2) A guaranteed income as our automatic stabilizer ( Friedman and Charles Murray )
3) See Brittan's current post with other suggestions from Friedman that I support ( this addresses the problem of Spender Countries needed to spend more in the short term )
4) In the US, a stimulus of:
a. Infrastructure
b. Sales tax decrease ( notice the recent analysis about the VAT decrease in the UK )
c. Targeted tax cuts for investment
In my opinion, these would have done a better job of getting the kind of behavioral incentives that Shiller correctly wants.
We should have also had a Swedish Plan for Banks, etc., but that was a monster headache to implement. We should also have a massive investigation into fraud, collusion, negligence, and fiduciary mismanagement.
Obviously there were a number of things that we could have done earlier, but I'd rather focus on the here and now.

We should also move towards a system of Narrow/Limited Banking ( Friedman and Fisher ), complemented by a financial sector that is supervised, self-insured, and not government guaranteed, to the extent that anyone actually ever believes that, with a Lender of Last Resort in existence. We should also tax or penalize the size of banks and financial concerns.

Cooperation at the international level would be wise as well, but the US and UK getting right would do a lot to encourage other countries going forward.

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