Thursday, February 05, 2009

Blind Men and the Elephant: On the Urgency of Asset Price Reflation

You've surely heard of the six blind men and the elephant. If we adapt the traditional story to our current financial and recessionary crisis, the key role-players become:
  1. The Fed, who figures that the money supply and interest rates are what matter, and proceeds to lower short-term rates all the way to zero percent, while starting open-market purchases of commercial paper and mortgage securities to reel in credit spreads;
  2. The Treasury, who decides that weak banks are the problem, and spends $350 billion of TARP funds recapitalizing banks and financial institutions, and deliberates over details of how to deploy the remaining $350 billion;
  3. The FDIC, who feels that confidence in the financial system matters most, and boosts deposit insurance limits to $250,000 to help prevent runs on the banks;
  4. Democrats in the House and Senate, who are sure that our problems will go away if the government spends more without worrying so much about the deficit, and quickly assemble a massive $900 billion stimulus package;
  5. Republicans, who are certain that only tax cuts matter, and refuse to support the Democrats' proposal; and
  6. President Obama, who believes that jobs and working together matter most, and pushes to get his stimulus package passed to jump-start creation of the 3 million jobs being forecast by his economic advisers, while reiterating his willingness to compromise for the sake of expediency.
That's six governmental players and six differing viewpoints, each of which may be construed as complementing the others, but together still falling short of definitively identifying the beast they are touching. In the traditional story, the six blind men do not realize that it is an elephant; and in the case of our economy, the elephant that everyone is touching but not seeing is an obvious truth that has gotten lost in the debate.

You see, the publicly spoken solution to our economic crisis--which seems like it ought to go away if only interest rates were lower, if the banks had more capital, if depositors and consumers had more confidence, if the government were to spend more to stimulate demand, if we had lower business and personal taxes, or if we could replace lost jobs--is really missing one essential ingredient. The elephant that everyone is touching but not quite comprehending (or at least not openly acknowledging) is the pressing need for a reflation of assets, home prices in particular.

In what now seems like quaint history, our economic woes began with a "minor" subprime mortgage problem in the middle of 2007. Through an unfortunate combination of regulatory leniency, misplaced incentives, financial irresponsibility and sheer Wall Street greed, a sizable number of underqualified, overleveraged borrowers began to have difficulty paying their mortgages and, as home prices fell, found themselves "upside-down" with negative equity, holding mortgages exceeding the value of their homes. Mortgage problems quickly spread to other highly leveraged borrowers as well, and over the ensuing year and a half have precipitated a downward spiral of plummeting real estate and stock prices, loan defaults and foreclosures, deteriorating bank balance sheets, abnormally tight credit markets, depressed consumer demand, a rising number of layoffs, etc.

Some wisdom may be gleaned by going further back in history to the last time our economy faced a crisis of this magnitude. As described by Irving Fisher in 1933, the basic problem we are experiencing is over-indebtedness, which leads to price deflation, which in turn makes matters only worse:
"[I]n great booms and depressions [the] two dominant factors [are] over-indebtedness to start and deflation following soon after. . . .

"Debt liquidation leads to distress selling and to . . . contraction of deposits and of their velocity . . . [which] causes . . . [a] fall in the level of prices, . . . [a] still greater fall in the net worths of businesses, precipitating bankruptcies and . . . [a] like fall in profits, which . . . leads . . . to . . . [a] reduction in output, in trade and in employment . . . to [p]essimism and loss of confidence, which in turn lead to . . . [h]oarding, . . . [all of which] cause . . . [c]omplicated disturbances in the rates of interest.

"[I]t is always economically possible to stop or prevent such a depression simply by reflating the price level [bold added] up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."

(Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica, 1933, pp. 337-357)
Indeed, it is curious that, although we all recognize our over-indebtedness and are suffering through painful dislocations because of it, no policymaker is placing front-and-center the glaring need for asset price reflation.

In addition to the Fed's policy of keeping inflation moderate, which is a long-run strategy to stabilize the rate-of-change of prices, current crisis-oriented policy must target a short-run higher absolute price level, if we are to steer ourselves out of the mess we are in. Essentially, we need to re-create wealth by reflating asset prices, as quickly as possible, up to a high enough level to make our bad debt problem go away. When the relationship between home prices and indebtedness returns to a more manageable level comparable to where it was prior to the onset of our current crisis, we will find that those underwater mortgages are not so underwater anymore, that the banks are no longer on the verge of bankruptcy, that consumer confidence and retail sales are rising again, that companies are no longer laying off workers, and that our economy is finally on the road to recovery.

Two recent news items are relevant here:
  • Senator Johnny Isakson has proposed a homebuyer tax credit, approved last night by voice vote in the Senate for amendment to the stimulus package being worked out. The measure "would offer new homebuyers a tax credit of up to $15,000 or 10 percent of the purchase price of a house that could be spread over two years." This tax credit would create increased demand among homebuyers and is fairly direct way of supporting home prices. In my opinion, the legislation should be amended to offer even more stimulus to the housing market and economy, by both a) raising the upper limit on the tax credit to $50,000, and b) allowing the amount of the credit to be carried forward indefinitely and applied to taxes owed until used in full by the taxpayer.
  • UCLA economics professor, Roger Farmer, proposes that "just as it sets the fed funds rate to control inflation, the Fed should set a stock market index to control unemployment." Targeting the price level of a stock market index, like the S&P 500 or even a broader index, would give the Fed a more direct handle on influencing performance of our economy. With our wealth as a society linked to the stock market, consumer psychology (which determines demand) is impacted more by a 10% drop in stock prices than by a substantial change in short-term interest rates. The Fed should continue to use all of the existing tools at its disposal--rate cuts, open-market operations and so on--and with an added mechanism for targeting for stock prices, policy objectives would become clearer and more effective, particularly in market environments like the present with standard interest rate easing already pinned to its zero percent lower limit.
I like to think that the actions of policymakers matter more than their words, but, particularly today with our global economy in crisis, vocalizing a credible plan with concrete and realizable objectives can make a difference. If Obama, Geithner, Bernanke or another official in a position of authority would openly acknowledge a policy objective of asset price reflation--the need to raise the prices of homes, other real estate and stocks--then we would at least be looking the elephant directly in the eye. Thereafter, the task of getting our stubborn economic elephant to move in the right direction would become more straightforward.