Time is NOT our friend. Time is our enemy.

TO BE NOTED: From Naked Capitalism:

"Guest Post: Channeling my inner Larry Summers

Submitted by Edward Harrison of the site Credit Writedowns.

Now that the results of the stress tests have been revealed, I would like to share a post with you that I wrote on Credit Writedowns about two weeks ago. In this post, my operating assumption was that the stress tests were a grand charade. Summers and Geithner had no intention of signalling to the marketplace that the U.S. banking system or even individual banks were sick. They were merely biding time for the companies to raise enough capital or to earn their way out of trouble. Time is our friend.

When I read Yves’ compelling post "Details on Banks' Victory Over Treasury in Stress Tests Emerge" based on a Financial Times story this morning, it confirmed my view. Now, the essence of Yves' post was a revelation that the Obama Administration has worked out deals with the large U.S. banks in which they will not be required to raise the amounts of capital needed under the recently released stress tests if the can earn their way into a better capital position.

This makes plain a key assumption under which I have long felt the U.S. government under both Bush and Obama has been operating. The fact that American banks could earn their way out of recession is a claim I have made several times (emphasis added).

• Paulson’s Economic Patriot Act is about marking to market (Sep 2008)

Under Paulson’s Economic Patriot Act, taxpayers will be on the hook only if these assets the Treasury plans to buy are overvalued. They might even see a gain if they are undervalued. Paulson is clearly betting that the assets are undervalued.

But even if they are overvalued and more writedowns are likely, Paulson certainly believes he can prop up asset prices, at least temporarily. This buys banks time. Time is an valuable asset here because:

1. it may give banks enough time to consolidate the industry
2. it may allow banks to earn their way out of trouble due to the steepness of the yield curve
3. it may give Congress enough time to come up with a new, better plan once the new President comes into office in 2009.

• Bailouts: catching a falling knife (Jan 2009)

Banks can earn their way into a greater capital base by making money on the spread between borrowing and lending. Marshall Auerback wrote a post demonstrating that the Fed is secretly trying to accomplish this (see Bank of America: Bailout hides huge bank subsidy deep in press release text).

• A few thoughts about the banking crisis response in the United States (Mar 2009)

First, I should note that Warren Buffett has said Wells Fargo has a pre-tax earnings power of $40 billion. That is enormous. While one should be suspicious whether Buffett is talking his own book, it points out the fact that any bank can ‘earn its way out of insolvency’ if given enough time. Nationalization is but one option. (John Hempton has noted that the Japanese banks actually did not have the benefit of time as their spread margin was so small due to the infamous zero-interest rate policy - you need a steep yield curve).

I should also note that John Hempton has two good articles out recently also arguing that American banks can indeed earn their way out of capital inadequacy because of the net debtor position in the U.S. The excess savings in the Japanese scenario is a principal reason why the banks there have remained under-capitalised zombie banks for so long. See his posts, they are good reads (Why American banks will not wind up looking like Japanese banks - Part 1 and Muddling through – why the American banking system will not turn Japanese – Part II).

I write all of this as a lead in to demonstrate that the stress tests were not tests in the normal sense at all. As Mark Thoma indicated, it was a test on a forced curve, rigged so that everyone would pass. We are simply biding time so that things can get better. Time is our friend. But, if all else fails, there is always Plan B (debt-for-equity swaps, nationalization and FDIC seizure).

Now, here is the post. It is fairly long, but I hope it gives you food for thought.

This is a thought experiment, so bear with me.

I have written repeatedly how I felt that the U.S. Government's plans to save the banking system were not adequate in the face of a severe capital shortfall in banking.

On one level, I cannot understand the seemingly blinkered view now being taken in Washington by the Obama Administration. However, I do have immense respect for the intelligence and experience of the Obama economic team, which includes Tim Geithner, Christina Romer, and, critically, Larry Summers.

Summers is nominally the Director of the White House's National Economic Council for President Barack Obama. But, I imagine he has much more influence given his experience in government and finance. Therefore, I have decided to take a different tack and write a post as if I were Larry Summers thinking out loud and laying out a plausible and logical framework which underpins the banking plans of the Obama Administration.

What follows is me channeling my inner Larry Summers. I hope to conclude with some closing thoughts after I step 'out of character' and review what my inner Summers has written.

Cue Larry.

In Character

Last year, we witnessed a breakdown in the fabric of the global financial system of a severity that few have anticipated. To be sure, there are those who had prognosticated a calamity of this type. Yet, the large majority of us in economics, finance and government simply did not imagine anything as severe as we have witnessed.

The question I asked myself before taking on my present role is this: Can I help the President restore full confidence in our banking system with a minimum of cost and a minimum of government intervention, cognizant of enormous political constraints. I believe I can. In order to do so, I have to lay out a mental map of what my key assumptions about the global financial system and deflationary environments are and what the key political and legal constraints are as well.

Assumptions

1. The economy is self-equilibrating. That means I reject Hyman Minsky. It also means that market forces will naturally bring the (U.S. and maybe the global) economy into line over time. In the interim, some pretty terrible human suffering can take place, but the pain of recession/depression is temporary. Equilibrium will return.
2. The natural course of the economy is up. Humans will continue to progress over time. We will use our intelligence to collectively become more productive, grow richer, and increase wealth. As a result, in most instances, time is our friend. We can grow our way out of economic difficulty.
3. Government is necessary. The essence of government is to do for its citizens what they cannot do for themselves. In my view, one of those things is to ease (though not eliminate) the suffering associated with economic downturns. This means that it is necessary for government to intervene in periods of severe economic dislocation, not to right self-equilibrating markets, but to hasten the return to equilibrium.
4. Government should be limited. By that I mean we must respect a healthy tension between the necessity of government and the limits of government. Government intervention, while often necessary, distorts market forces, and must, therefore, be limited. This certainly means that competitive, deregulated markets are preferable to over-regulation and anti-competitiveness. In finance, we probably got the regulatory mix wrong during the 1990s and that fostered an industry climate which contributed to excesses. This will change, but not in a way that will lead to over-regulation.
5. Government stimulus is effective in a deflationary environment. It stops a potentially devastating deflationary spiral, eliminating worst case outcomes that result from dead-weight economic loss. Yes, this stimulus can pull demand forward or crowd out the private sector, both of which are bad. But, ultimately, the priority of government must be to end a deflationary spiral because of the attendant dead-weight loss it creates. (dead-weight loss being economic destruction that should not and would not take place in a non-deflationary environment).
6. The U.S. banking system is fundamentally solvent and is suffering from liquidity problems. The last 25 years did see excess where the financial industry in the U.S. grew to outsized proportions. Asset prices rose too high. But, things have overshot. The U.S. is more productive and wealthier than at any time in the past. Our banking system should reflect this. However, liquidity constraints and asset price falls driven now by fear are making our system look weaker than it actually is.

Constraints

1. The checks and balances of democracy necessarily lead to a sluggish response in crisis. So be it. That is democracy in action. If I had the power to dictate, I might be able to fashion a financial crisis plan which would work. However, the legislative and judicial branches are going to slow what could be an optimal response by effecting the system's necessary checks. It is incumbent upon the President to respond to crisis in a manner both respectful and cognizant of these constraints but using all available resources available to him.
2. The government cannot fund itself with deficit spending ad infinitum. Contrary to what Dick Cheney claimed, deficits do matter. Debt is a claim on future income and an increase in these claims erodes future growth at the expense of current consumption. To the degree that government finances current expenses with debt -- and not tax and income -- we should expect an erosion of future growth. This fact sets up a tension between the need for government to spend in crisis and the erosion of future growth this spending might create. When push comes to shove, I choose deficit spending in crisis.

Banking system

So given those assumptions and constraints, the question is how do we deal with this crisis. The first priority must be to forestall a deflationary spiral because that induces a dead-weight loss and extracts a cost of incalculable consequences. The best way for government to end the spiral is to temporarily increase spending or temporarily induce more private sector spending. Is this re-flating the bubble? No, because deflationary forces will continue to extract a price even with these measures in place. The key is to avoid a negative feedback loop, a spiral downward, and the easiest way for government to do this is to increase spending.

But, spending alone won't get it done. Ultimately, we will need to increase credit availability. Just because people are spending more, does not mean the economy will grow. Growth depends critically on increasing credit in line with the growth of the economy.

I am not one for nationalization of banks or other coercive, non-market based mechanisms of getting lending flowing. The concept that nationalizing banks and re-privatizing them should be a first port of call for a government imperiled by a weak banking system is contrary to the need for limited government. What we need to do is put a number of government-assisted programs into play -- cognizant of that healthy tension between limited government and necessary government -- and get credit flowing this way.

Let me enumerate some mechanisms:

• First we should try bank re-capitalization. Our first priority must be to have an adequately-capitalized banking system. Absent that, increases in lending are impossible and the system will continue to be doubted. So that's number one. We can do this through preferred equity so that the government is senior to common equity and receives some compensation for taxpayer money. What's more is it limits government interference. Remember - most of these institutions are having temporary problems. With enough capital, they can weather the storm. There is no need for heavy-handed government interference.
• If re-capitalization proves inadequate because of depreciated legacy assets, we will need to remove those assets from banks’ balance sheets in a way that promotes price discovery, increases asset liquidity and respects the tension between government involvement and government’s limitations. The PPIP and TALF can help achieve this.
• Moreover, by allowing financial institutions to borrow with a government guarantee, we can ease the funding liquidity constraints as well.

Ultimately, the jump start from stimulus and quantitative easing will start to kick in while all of this is ongoing. The result will be a growing economy and healthier banks. Nevertheless, we should implement some stress tests on institutions to gauge how much capital each institution would need in a worst-case scenario. Those banks faring poorest will need to take remedial action as soon as possible. However, under no circumstances should we ever imply that any individual institution is insolvent. This creates doubt and during times of stress it is not the wisdom of crowds, but the panic of crowds that is on display. Doubts about one institution are likely to have knock-on effects for others creating a systemic problem. This must be avoided at all costs.

Obviously, if these plans do not work out because the economy declines more than expected, we can always fall back to the more coercive, interventionist mode of nationalization. However, that is Plan B only – measures to be taken only if necessary.

I am confident these plans will work. We are already seeing some faint signs of recovery. Mind you, unemployment will continue to rise at a devastating clip. But, by the second half of 2009, we should see some many more signs of recovery and with all of these plans in place, the liquidity crisis will recede into the past.

Stepping out of character

Whew. Now I can step out of Larry Summers mode and move back to Edward Harrison mode - I was starting to believe this stuff.

The truth is that I sympathize with the logic above. There is much to believe in the preceding paragraphs. In a best-case scenario, Summers would be right if this is the line he is taking.

But what about worst-case scenarios? Where I differ is the one line " in most instances, time is our friend. We can grow our way out of economic difficulty." The whole edifice depends critically upon that one statement. If this statement turns out to be false, the whole logical construct collapses. I prefer to go -- as the Germans would say -- "auf Nummer sicher (with the sure thing)” and not have my plan hinge critically on one potentially false assumption.

Time is NOT our friend. Time is our enemy.

1. The economy will worsen considerably more. The stress tests indicate a worst-case scenario which is unrealistically optimistic. The necessary corollary of this statement is that the legacy assets which are already impaired will become more impaired. In a worst-case scenario, many institutions will be insolvent.
2. Balance sheets will worsen because of commercial real estate loans, credit card loans and other real economy effects as well. This double whammy of deteriorating legacy assets and new asset impairments in a worst-case scenario will overwhelm the programs now in place.
3. Political capital will be consumed over time. Americans will tire of this crisis. And, therefore, the natural checks and balances in the system will stymie further efforts. The legislative branch will re-asset itself in the government budget process and in the financial sector oversight process. The judicial branch will be called on to take issue with the turn of events. Obama is not going to get more stimulus. He is not going to get additional funds to re-capitalize banks. And he will not get a free hand in administering these programs already in place. Moreover, the Fed’s quasi-fiscal role will cause a backlash from Congress and risk its independence.

I have other objections but this post is getting much too long in the tooth. So I will leave it to you to make others.

What worries me is that behind Summers’ (and Geithner’s) calculus is a belief that the system is fundamentally sound and that we should not upset the cart. In my view, the last 25 years of U.S. growth have rested mostly on the creation of debt in complete disproportion to the economic growth the debt has engendered. This has meant we have consumed more in the last generation than we could possibly afford without cutting back our standard of living for at least the next generation.

Add in the belief that this is about asset prices overshooting to the downside and a banking system which is fundamentally sound and you have mental constraints which could prove catastrophically limiting.

I will have more to say about this in upcoming posts, but I do hope you enjoyed seeing the other side of the debate."

Deflation can result in a downward spiral that can be difficult to reverse.

TO BE NOTED: From the NY Times:

"Spain’s Falling Prices Fuel Deflation Fears in Europe

By NELSON D. SCHWARTZ

VALENCIA, Spain — Faced with plunging orders, merchants across this recession-wracked country are starting to do something that many of them have never done: cut retail prices.

Prices dipped everywhere, from restaurants and fashion retailers to pharmacies and supermarkets in March. Hoping to increase sales, Fernando Maestre reduced prices by a third on the video intercoms his company makes for homes and apartment buildings. But that has not helped, so, along with many other Spanish employers, he is continuing to fire workers.

The nation’s jobless rate, already a painful 15.5 percent, could soon reach 20 percent, a troubling number for a major industrialized country.

With the combination of rising unemployment and falling prices, economists fear Spain may be in the early grip of deflation, a hallmark of both the Great Depression and Japan’s lost decade of the 1990s, and a major concern since the financial crisis went global last year.

Deflation can result in a downward spiral that can be difficult to reverse. As unemployment rises sharply and consumers cut spending, companies cut prices. But if sales do not pick up, then revenue can decline further, forcing more cuts in workers or wages. Mr. Maestre is already contemplating additional job and wage cuts for his 250 employees.

Nowhere is this cycle more evident than in Spain. Last month, it became the first of the 16 nations that use the euro to record a negative inflation rate. The drop, though just 0.1 percent, had not happened since the government began tracking inflation in 1961, and Spanish officials have said prices could keep dropping through the summer.

Some of the decline came as volatile food prices sank; the cost of fish fell 6.2 percent, and sugar was down 5.7 percent. But even prices in normally stable sectors like drugs and medical treatments fell 0.7 percent in March, and there were slight declines in footwear, clothing and prices for household electronics.

“Alarm bells are going off,” said Lorenzo Amor, president of the Association of Autonomous Workers, which represents small businesses and self-employed people. “Economies can recover from deceleration, but it’s harder to recover from a deflationary situation. This could be a catastrophe for the Spanish economy.”

Deflation is not just a Spanish concern. Luxembourg, Portugal and Ireland have reported price drops, too. While the declines have been slight — and prices rose modestly after factoring out food and energy prices, which can fluctuate widely — other figures released this month suggest the risk of deflation is growing.

In Germany, wholesale prices dropped 8 percent in March from a year ago, the steepest fall since 1987. In Japan, wholesale prices fell 2.2 percent on an annual basis. In the United States, the Consumer Price Index fell 0.1 percent in March, year over year, the first decline of its kind since 1955, though prices rose 0.2 percent excluding food and energy.

“It doesn’t mean it will spread here to the U.S., but we need to look closely at Spain and other places to understand the dynamic,” says Simon Johnson, a professor at the Sloan School of Management at the Massachusetts Institute of Technology and a former chief economist for the International Monetary Fund. “It’s like the front line of a new virus outbreak.”

The trends have unnerved even well-established businesses. “There is such a huge lack of confidence in the politicians, in the European Union and in the banks,” said Arturo Virosque, 79, president of Valencia’s chamber of commerce and the owner of a local logistics company. Ticking off crises going back to the Spanish Civil War in his youth, he said, “this is different. It’s like an illness.”

After price cuts by competitors, Mr. Virosque’s company reduced charges for storage and transportation, and slashed its work force to about 170, from 250. “The worst thing is that we have to cut the young people,” he said, because higher severance makes it too expensive to fire older workers.

While unemployment traditionally is higher in Spain than in much of Europe, the sharp increase has many here nervous. The jobless rate for those under 25 is at a Depression-like level of 31.8 percent, the highest among the 27 nations of the European Union.

Before cutting prices in early 2009, Mr. Maestre ordered several rounds of job cuts at his company, Fermax, as sales of the intercoms collapsed with Spain’s housing bubble.

“It’s a question of survival for everybody,” he said. Still, the lower prices have not translated into higher sales. Fermax’s orders fell 25 percent in the first quarter. Prices for some intercom parts that he buys, like video screens, have also come down, but it is not enough to make up for the sales drought. “Prices have to come down more and we will have to spend less,” he said.

The effects of this downward spiral are evident at Valencia’s principal soup kitchen, in an imposing stone building constructed a century ago as an alms house. Each day, a line forms around the block by noon. The Casa de la Caridad, or House of Charity, is helping three times as many people as it did a year ago. More than 11,000 meals were served in March, and it expects to top 12,000 this month.

As the economic decline has broadened, so has the range of people seeking help. In the past, most were out-of-work immigrants or the homeless, said the center’s director, Guadalupe Ferrer. Today, “it’s more and more people like us who had a house, a respectable job, but are now unemployed.”

The employed worry that falling prices will endanger their jobs as well.

Yolanda Garcia has worked as a butcher under the arches of Valencia’s soaring Art Nouveau central market for a decade, but she’s troubled that a drop in the price of chicken, to 5.99 euros a kilo, from 6.99, has not attracted more customers to her stall.

“Of course, we’re worried the boss will have to reduce staff,” said Ms. Garcia, 38, whose husband, a construction worker, was laid off two months ago.

All this has made deflation, once a subject largely reserved for economists who studied the Great Depression, into front-page news here.

The American economy is less vulnerable to deflation, in part because of the Federal Reserve’s decision to cut interest rates to near zero and increase lending by $2 trillion. The European Central Bank has also cut rates, though more slowly, and it has resisted the lending measures adopted by the Fed and the Bank of England to prop up spending.

When Spain had its own currency, the peseta, the central bank could have simply devalued it, or cut interest rates to zero. But that is not an option in the era of the euro, when monetary policy is controlled from the European Central Bank’s headquarters in Frankfurt, said Santiago Carbó, a professor of economics at the University of Granada.

“If we enter into a deflationary period, we won’t have the monetary tools to sort it out,” Mr. Carbó said."

This combined with a weak economy and an unresolved financial crisis could in theory lead to a deflationary spiral

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy"

"Uncertainty as defined by Larry Summers (or just another example of a two-handed economist?)

In an interview last week, Larry Summers said that "there are risks of both deflation and inflation", so anything is possible... In defense of Larry Summers' lack of commitment when it comes to forecasting inflation, there is indeed an outgoing debate between those who are afraid that advanced economies are heading into deflation and those who believe that the aggressiveness of monetary policy (and the expansion in the central banks' balance sheets) will soon produce a large and persistent increase in inflation rates.

To some this might sound like the standard two-handed approach of economists but I think that in this case the debate is also reflecting an unusual amount of uncertainty as we are dealing with an episode that is different from what we have seen before (of course, as an economist, I have to defend the profession...).

There are two reasons for why uncertainty can be so high. First, this is the deepest recession for many advanced economies after WWII. While there are some historical episodes of even deeper downturns (such as the Great Depression), they took place in a very different economic, political and institutional environment. In addition, some of the monetary policy actions that central banks around the world are taking can be seen as an experiment (out of desperation). Traditional monetary policy actions are not enough so they need to try unorthodox measures. Yes, we have a sense on the consequences that these actions will have but we do not have previous historical experiences to produce a good quantitative estimate. If you want to look at how this uncertainty is reflected in differences in inflation forecasts, here is an interesting entry from the macroblog at the Altlanta Fed on the current state of inflation expectations and uncertainty.

The deflation scenario is one that is supported by the data. Today, the U.S. Bureau of Economic Analysis released the CPI estimate for March and on an annual basis, inflation was -0.4%, the first time this measure is negative since 1955. This combined with a weak economy and an unresolved financial crisis could in theory lead to a deflationary spiral. However, one has to be careful reading too much into the figure that was released today. If one looks at the details, the only category where we had deflation was in "transportation", which is driven by the decrease in oil prices over the last 12 months. Falling oil prices is, if any, good news for the US economy. Other items display inflation rates that were clearly above zero on an annual basis (Food and Beverages at 4.3%, Education at 3.2% and Other Goods and Services at 5.7%). The trend looks somehow more worrisome as on a month to month basis we see negative inflation rates across more categories in some of the most recent months, but it is fair to conclude that we are still far from the type of persistent deflation that can cause major damage to the economy.

The inflation scenario is driven by the massive increase in the balance sheets of many central banks (including the Federal Reserve that has probably been the most aggressive of all). We know that this increase in the balance sheets has not translated into a one-to-one increase in the money supply (see earlier entry about the money multiplier), but there is still the risk of inflation if central banks do not react faster and withdraw the additional liquidity when the economy recovers. Simon Johnson has recently written an article in the Washington Post summarizing the inflationary risks of the current monetary policy "experiment". Theoretically, the Fed has the ability to do what it needs to be done to avoid inflation (see, for example, this article by Woodward and Hall on the potential use of the interest rate paid on reserves).

So what will it be, inflation or deflation? If central banks are good at what they do and they quickly react to the different potential scenarios ahead, we should not see any of the two (i.e. we should see an inflation rate that remains positive but around or below what is considered to be the -explicit or implicit- medium target for central banks).

Under which conditions can central banks fail? On the deflation scenario, the failure would be one of anticipation. As long as central bank are ahead of the curve and provide the necessary liquidity using whatever means are necessary (including the "helicopter money drop"), they should be able to keep their economies from falling into persistent deflation. On the other side (the inflation scenario), there are potentially two risks: a technical one and a political one. From a technical point of view, central banks also need to anticipate changes in inflation expectations and move as fast as they can to avoid any sustained increase in those expectations. The second risk is more of a political nature. One can envision scenarios where the central bank could be under enormous pressure to give up and let inflation increase above its normal level. If the economy recovery is slow but still fast enough to get inflation expectations increasing, undoing the monetary expansion could have a large impact on the interest rate. An increase in the interest rate will impose a serious cost to governments who are currently accumulating debt at a very fast pace because of large deficits. And if growth is not strong enough to bring the necessary tax revenues, governments will feel the need of either raising taxes or cutting spending, none of which are easy from a political point of view. No doubt that this will be an interesting test of the independence of central banks. We have already seen in recent months central banks deciding on actions that "they did not want to take" but it was necessary because of the "special circumstances". If inflation expectations come back too early, the trade off between inflation and growth (and interest rates) will be very strong. Would it also be considered a special circumstance that requires unusual actions by central banks? Let's hope we do not get there and we do not need to test the independence of central bankers.

Antonio Fatás"