Here is Housing Doom’s sixth installment of our unauthorized annotated transcript of the American Enterprise Institute’s October 30, 2008 seminar "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?" [1] This is the presentation by John Makin. He does not make use of a slide deck. Here is the official transcript. There is a video and an audio-only recording of the event at the event site.
Highlights
John Makin [1:11:10]: Thank-you Alex. Well, as I was listening to the previous speakers I was reminded that it’s almost Halloween, and the favorite movies at this time of year are called Chainsaw … [laughter] I think we’re up to Chainsaw IV now. And certainly our discussion here is related … strikes me as the kind of mayhem that we see in those films. But …
I’m going to try to take a little more top-down view. I think maybe a little bit along the lines that Nouriel has done. I think that it’s very important to look at these things on a case-by-case basis, and also on a systemic basis and my bottom line is that all of the lines and graphs and things that you see in Tom’s chart book and in Chris’ and some of the others are all conditional lines. They’re systemically conditional.
That is, that bottoms-up analysis has to be modified in a world where there is substantial systemic risk. So that the whole outcome here is conditional on what’s going on in the US economy, and our focus here has been the deflating housing and mortgage bubbles in the United States, but I think one of the things that this Session IV has revealed to us, or has brought us to a point where this is a global issue, and that we’re not just looking at what’s happening to the housing sector.
We started off with subprime, then it was the mortgage sector, then it was the derivative-based mortgage sector, then it was the housing sector, then it was the financial system, then it was the US economy and now we’re also talking about the global economy. And what I think … if I could describe briefly what’s happened, it is that we had a bad credit crisis in the US — maybe we’re half-way through it if the world economy doesn’t collapse — That has induced the movement into a severe recession for the US, and that in turn has implications for the global economy and will feed back negatively onto the problems in the housing and mortgage sectors.
So that’s a dynamic that’s fairly well understood — or has become to be fairly well understood — that I don’t … I would have to say that our policy-makers are still not acting as if they fully understood how bad a dynamically unstable adverse feedback loop is. That is, credit gets worse, the economy gets worse, credit gets worse, … That’s not good. The vortex analogy or metaphor is operating now.
So, why? … and Nouriel listed — and I’m in admiration, I’m in awe at how he can remember every one of the steps that the Fed and the Treasury has taken over the last past 4 months [laughs], as frankly I’ve lost track — One of the reasons I’ve lost track is, as many of the speakers have suggested, it doesn’t seem to make any difference. That is, that’s eventually not going to be the case, but I think Nouriel went through the action / reaction pattern that we’ve seen, starting with the Bear rescue and the 8 week rally to the last and larger and more systemic approach to the problem and a 1 day rally in the financial markets.
So in my past two economic outlooks, the first one I wrote at the end of September [1:15:00] was called, "Panic," and the next one that I just finished last week is called, "More Panic," and I think that captures pretty well what’s going on in the financial sector both domestically and globally, and the implications for the real economy are dangerous.
So what I’m trying to figure out is — why isn’t anything working? … or why doesn’t it seem to be working? … or why after we take what seemed to be substantial steps, and almost unlimited commitments of funds are we still experiencing what seems to be an accelerating negative adverse feedback loop? And a couple of suggestions: First of all — and this goes back to how these crises develop; well known phases, we have a shock, the shock was probably … well call it Bear Stearns …, we have denial, that was the stock market rally, we have efforts to make more things right, and then we get into panic, and we’re not yet integrating the problem — so what’s going on here?
Well let’s first look at the US. In the US, the Fed’s response is essentially goes back … if you go back — and here I’m relying heavily on reading the histories of the Great Depression in the United States and the Depression or whatever you want to call it in Japan during the 1990s: in other words bubble bursts, aftermath — what are the lessons?
And the first lesson of the Great Depression, if you read Friedman and Schwartz "Monetary History [of the United States, 1867-1960]," which I highly recommend, it is that you don’t … the central bank should not let the money supply fall, and should not as the Fed did at that time actually excentuate the drop in the money supply by noting that interest rates are fallng and suggesting to itself that … oh, there must be plenty of cash around because interest rates are going down.
So in an environment where a bubble has burst and there’s an endemic collapse, it’s probably not a good idea for the central bank to essentially cut the money supply by a third as the Federal Reserve did between 1930 and 1932. Because that coincided with the onset of a very nasty deflation and a collapse in industrial production like nothing we have seen now. Just look at the pictures.
And what was happening there was straightforward. The collapse in the stock market and the negative effect on the real economy made banks very cautious. Banks were hoarding money and as the Fed collapsed the monetary basis — the so-called money multiplier, which is really a measure of how much … how active the banks are in utilizing the reserves provided by the Fed — the money-multiplier was collapsing and the money supply was collapsing.
Well the good news today is that although the money supply [...] the monetary base I should say, the stuff that the Fed puts into the system is not collapsing, the money multiplier is collapsing … and so the supply of money is not growing very fast because the banks are not operating as financial intermediaries. Look at the amount of funds that the Fed has pumped into the banks. They’ve said, well bring us your toxic crap and we’ll give … well … we’ll take it. [laughs] And it will make you more liquid.
But the liquidity in the banking system has not created any kind of lending. The big triumph of the last 2 weeks is that after hefty cajoling and the injection of plenty of cash the banks have started to think about not lending to each other at a lower interest rate — that that’s the so-called LIBOR story — before they weren’t lending to each other at 4 percent. Now they’re not lending very much to each other at 3 percent. If that make you feel better, be my guest. The folks on CNBC every day jump up and down and say, "oh, LIBOR’s down, it must be wonderful." [laughter]
And even if the banks were lending to each other, they’re certainly not going to lend to you or me or anybody else for that matter, because of the stories that we’re hearing up here, banks are in a risk-reduction, deleveraging mode, and so there’re not about to lend. The injections the banks got their checks from the Treasury on Monday, and of course as we learned when an enterprising New York Times reporter snuck onto a conference call for JP Morgan employees, learned that the JP Morgan management was telling its employees — don’t worry, those capital injections aren’t going to go anywhere but to acquire other banks. Certainly we’re not going to lend it out in an environment like this. We’re beginning to worder if this is working very well. [1:20:00]
Well, so what’s going on? The supply of liquidity in the US is not growing because the multiplier is falling so fast, even though the Fed is injecting tons of money. OK, that’s one problem. And in the last outlook called "More Panic" I went to John Maynard Keynes to look at the other side of the problem — what’s happening to the demand for money. And I took pains to remind my readers that there’s a big difference between Keynes and Keynesians. Keynes was a brilliant monetary theorist. I spent a lot of time in the "Money" course at Chicago and at the "Money" workshop at Chicago where Milton Friedman made it amply clear that he was a great admirer of Keynes, not of the Keynesians, and what Keynes understood was that in an environment like the current one the demand for money can rise very rapidly. Uncertainty is certainly something that increases the demand for cash. If you doubt that there is a big demand for cash look at the yield on 4-week T-bills. It has gone negative, and it’s very low because most prudent cash holders in the United States, myself included, but many other corporations and individuals, do not want claims on depository institutions, they only want claims on the government, i.e. T-bills, and T-bills are virtually cash now because cash is a non-interest-bearing liability of the government, and T-bills are becoming just that.
Now the best thing that’s been done on the policy front in the past month has been the establishment of widespread deposit insurance. So that institutions and individuals don’t have to be afraid of an interruption in access to their liquidity because they have deposits of more than $250,000 it Citi or JP or some other place. And if this became a real issue and finally the Fed figured it out that, gosh, maybe people are worried about their deposits at major institutions. Indeed they are.
So that was a good step, to say we were going to guarantee those deposits. The problem is that every institution whose deposits didn’t get guaranteed has suffered a drain on their holdings, and then the question about whether — and again the question about whether the liabilities of Fannie and Freddie are guaranteed, or effectively guaranteed has not been productive, let’s say.
So, the demand for liquidity, that is the demand for riskless claims on the government, has skyrocketed at a time when the …. increase in supply of those claims has been stable but not falling, and the fact that the money multiplier is collapsing means that it’s difficult for individuals to get hold of enough cash that is unconditionally guaranteed in a highly risky environment.
Other symptoms include — and the shortage of dollars by the way is global — the dollar has appreciated sharply in the past two weeks and some adjustment in the past few days because there were huge structures outstanding in the global economy where the people were short dollars.
You remember … the smart money in Europe was essentially saying — Oh, when the crisis comes the dollar’s going to collapse — so many structures were created which were essentially short dollar structures. Likewise the carry trade where you financed your trade in Japan and put the money elsewhere. All this thing is running in reverse and so there’s a huge excess demand for yen and dollars which the central banks have not fully satisfied, and so the countries which are experiencing an excess demand for their currency are experiencing a deflationary shock, which is what currency appreciation is. Prices go down when your currency gets stronger. You don’t want that in an environment like this.
So although one may puff up with pride that there’s a tremendous demand for dollars and yen one must be careful here.
So part of the reason that all of the efforts that we’ve seen undertaken here are not working is that we still are in the grips of a huge excess demand for safe liquidity. That has created an intensifying real economic slowdown, both in the US and globally. The slowdown in the UK is perhaps even more abrupt than the slowdown in the US. Europe is going into negative growth, the Japanese economy is in negative growth, [1:25:00] and in the last 3 days, after people said, oh they’ll never cut rates, the Japenese are saying, oh we’ll probably have to cut rates and do a big fiscal stimulus package.
So the other thing that’s happening here is the pace at which this is unfolding is blinding. And so one of the reasons that policy makers haven’t got on top of it is it’s simply moving too fast for them.
We are now in the US as far as monetary policy goes — yesterday we went to a 1 percent Fed funds rate — we are approaching the fairly well known zero bound problem that central banks face in situations of powerful incipiant and actual deflation where there is an excess demand for cash which has not been satisfied by the central bank.
And in that case, once the Federal Funds Rate is pushed close to zero, the central bank faces the zero bound problem. That is, if you crank up the Taylor Equation and you plug in an inflation rate of around 2 percent (it’s now 2.6) and an unemployment rate of 8 percent (it’s now 6) you find that the Fed Funds Rate that’s called for is minus 2 percent. Well, the zero bound problem is that you can’t set the Fed Funds Rate at minus 2 percent. You can only set it at zero.
So in that situation, where the equilibrium Fed Funds Rate is below zero, that’s sort of a red alarm bell that goes off and says, you really have to start printing money here because you have to arrest the deflation. Because if you don’t, and the Fed Funds Rate is zero, and the inflation rate is minus 3, what’s the real return on cash? 3 percent. I want more.
I get more, what happens to the deflation rate? It goes to 4 percent. Et cetera. So it is a dangerous, dynamically unstable disaster. Meanwhile, as deflation accelerates the real burden of the many debts, which we’ve seen in the charts here, goes up rapidly, and the system quickly implodes.
Alex Pollock: You’re getting to the end. One minute.
John Makin: I sure am. [laughter] We already imploded here.
OK, the end is easy. Or straightforward. At least as far as I can see. And that is the way you deal with this situation is that the central bank comes out and says — all right, we will print money to buy equity, we’ll print money to buy long term bonds, we’ll print money to buy anything. And we promise you folks that the inflation rate … I’m sorry … that the price level — be careful here — the price level next year will be higher than it is now. We promise you inflation.
And when the central bank gets around to promising you inflation, we will begin to move out of this crisis.
The central bank, and for 5 years I tried to convince the Bank of Japan that they had to do this, no success. And so they simply ended up in a lengthy recession / depression which didn’t end until they actually started printing money, and the world economy recovered in 2003, et cetera.
So when the Fed gets around to promising you that the price level next year will be higher than it is now, a lot of good things start to happen. The demand for cash goes down, the real burden of debt is relieved by a higher price level, and what are you doing? You are levying a large — I should say a broad-based — low rate tax on nominal assets.
And if in terms of my public finance theory, broad based low tax rates are a good thing. The tax rate is the inflation rate on nominal assets. So I’ll stop there.
Alex Pollock: Thanks, John. If you were going to find a way for real asset prices to come down, well nominal ones don’t fall as fast. Another way to say that … with your inflationary program. [1:29:11] …
Notes and References
[1]: "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?", AEI Event Homepage, October 30, 2008.
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