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.


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1:27 PM, February 06, 2009  
Anonymous Anonymous said...

How quickly we forget concerns of home affordability. Assuming we even have the means to reflate the entire housing market, that would merely put future home buyers in the same affordability bind that contributed to the current disaster.

Perhaps a better plan would be to replace underwater mortgages on primary residences with new mortgages which better reflect current home values. The mortgage holders would have to be willing to take a hit, and taxpayers will have to step in to make up the remaining gap. Hopefully at least a portion of the taxpayers' money could be protected with a lien on the property.

While this is obviously unfair to those of us who were less reckless with our finances, it may be the least bad solution.

More affordable homes are already selling - December home sales in California were up 85% y/y.

12:45 PM, February 07, 2009  
Blogger Greg Rudzinski said...

Rather than blind men and an elephant how about too many government financial cooks spoiling the economies broth. At this point it is hard to tell what actions are making a difference.


3:14 PM, February 07, 2009  
Anonymous Anonymous said...

Smart article, must be interesting to see so much big government when it something so alien to your economic system.

I am a private investor and always look for insight into the current economic bind.

2:35 AM, February 11, 2009  
Anonymous Anonymous said...

Cool post - always interested to see how the views from America match those from Europe.

2:37 AM, February 11, 2009  
Anonymous Anonymous said...

I believe in a simple thing:

You gotta pay the piper someday. Better to do it early and fast. It will be brutal but there is no other way.

So these "asset reflation" strategies, if implemented, will come back to bite us later.

Doing this is like a "greenspan put" for the masses. You don't want every american to spend/invest recklessly thinking that the great govt will bail them out.

You can't have 4% GDP growth for 6 yrs straight of which 3% was real-estate related. Productivity increases raise real incomes which can then reflate the real estate. So its time to get back to old virtues like "hard work", "thrift", "spend less than you make" rather than the current things like "stimulus checks", "spend your way out of recession" etc.

5:04 PM, February 11, 2009  
Blogger Johnny said...

I wonder why with you knowledge of Japan, you don't post about comparing our current deflation with the Japanese deflation.
I think politically, no one wants to talk about the "800-lb gorilla in the room."


6:39 AM, February 13, 2009  
Anonymous Anonymous said...

More regulation is the key to preventing this problem from reoccuring.
It is defeatist to say about the banks "they caused this mess and they should solve it", the banks need capital. However they should not get captial without significant reviews and improvements in lending practices.

6:17 AM, February 16, 2009  
Anonymous Anonymous said...

Asset price is only the superficial matters. Investor pull out their money from asset because they have no confidence in current financial systems. Does a high level of asset price can attract invertors? Maybe not. They may see this high level of price as another bubble, if our whole financial and economic system cannot have an overhaul. Over-consumption,over-indebtedness, which contribute to our past golden ages are now under critism.
Govenment should now take the responsibility to show people its commitment to a new style of economic growth.

7:22 PM, February 26, 2009  
Anonymous Anonymous said...

I have reason to believe that AIG is withholding profits in order to illicit bailout investments. Approximately 9 months from now, AIG will unveil these profits under the guise of stimulation caused by the bailout money. In truth, AIG is using this additional money for kickbacks for top executives and investment in expansion.

In truth, the banking crises is not as bad as it appears. Lehman Brothers was the only very weak cog in the system. In fact, many banks are artificially reporting losses in the hopes that it will generate media attention for them that will later pay off. In fact, AIG shares will boom from less than one dollar a share to over $8 a share in a short matter of weeks after they unveil the fact that they are back in the black.

So, how do I know this? I happen to have a very close friend who works at a high level position at AIG. This is more than just gossip. Right now, any of the major banks-but especially AIG-would be an excellent investment.

9:04 AM, March 11, 2009  
Anonymous Anonymous said...

Waha.. This is a story when i was young! Cute!

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Anonymous Melissa Hespin said...

Along with all of this, I am also wondering what the government has up it's sleeve for land owners. Are they going to suck the resources right out from under us too. Is it too much to ask that they get their act together? Are they going to nationalize the housing market too?

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Perhaps a better plan would be to replace underwater mortgages on primary residences with new mortgages which better reflect current home values.

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