Financial Conditions: Austere

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machinehead's picture
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Financial Conditions: Austere

Amid the flurry of 'double dip' recession warnings, I went looking for some quantitative data for background. A number of central banks and investment banks publish financial conditions indexes, which aggregate multiple data series such as interest rates, credit spreads, exchange rates, stock prices, economic surveys, and so forth to produce a single indicator, showing whether money is 'loose' or 'tight.'

One such indicator is the Deutsch Bank financial conditions index, renamed as the Monetary Policy Forum Financial Conditions Index (MPF FCI) after being rejiggered to include 45 different data series as ingredients in the composite index. The message from the MPF FCI is ugly: it's fallen halfway back to its post-Lehman crisis lows.

http://www.businessinsider.com/deutsche-bank-financial-conditions-just-dropped-back-to-crisis-levels-2010-6

Among the three largest contributors to the index's fall over the past two quarters, two are stock market related (weakness in the broad Wilshire 5000 index, and the elevated level of the VIX volatility indicator which typically accompanies stock declines).

No. 2 in the list of negative factors is strength in the Real Broad Trade-Weighted Dollar, as the euro and other currencies have devalued against the U.S. dollar. 

This interests me, because with the Fed Funds rate already pegged near zero, one possible 'unconventional measure' for easing monetary conditions is to devalue the dollar -- either directly through forex intervention, or indirectly by using measures such as quantitative easing to create a credible threat of future inflation. This is one reason why there's so much political howling for China to revalue the yuan -- it would make U.S. monetary conditions more stimulative.

David Rosenberg at Gluskin Scheff claims that the Federal Reserve's Taylor Rule would imply an appropriate target rate for Fed funds of minus 5 percent now:

What does not get enough play is that Fed policy is tighter than it should be right now. Based on the Taylor Rule, believe it or not — zero policy rate and the [growth] of the Fed’s balance sheet is equivalent to a -2% rate, when at this stage the two tools should be equivalent to a -5% rate.

And, fiscal policy is actually far less stimulative than meets the eye when the impact of state/local government restraint is factored into the equation. In the past two months, whether one looks at the Kansas City or St. Louis Fed’s stress indices, there have been 60 basis points of tightening in overall financial conditions, just as the economy is hitting a possible inflection point.

http://jessescrossroadscafe.blogspot.com/

The St. Louis Financial Stress Index mentioned by Rosenberg is shown below. It is constructed opposite to the MPF FCI, such that 'up' = 'tighter monetary conditions.' 

 

Obviously, an effective tightening is not helpful, at a time when the policy rate is being held flat on the floor to provide needed stimulus.

The UK Telegraph quotes Jim O'Neill, head of global economic research at Goldman Sachs, sounding a cautious note:

"If we are wrong (about estimates for growth in China) especially significantly, then the world will be a very challenged place, particularly for those living on self-imposed domestic austerity," he said. "What adds to the reality of this situation is that there appears to be growing evidence that China is slowing down."

The warnings come just days after Goldman downgraded its forecast for GDP growth in China this year from 11.4pc to 10.1pc.

While China is still growing, the outlook in the US is "distinctly chilly", Mr O'Neill warns, and the country could be threatened by a period of deflation.

The other danger highlighted by Mr O'Neill is the concern that too many G20 economies undertaking austerity measures at the same time could reverse the global economy recovery.

"All G20 members tightening fiscal policy at the same time as the UK's tough stance would make it hard to deliver on improving growth for all, or possibly any," Mr O'Neill explains.

http://www.telegraph.co.uk/finance/economics/7870324/Goldman-Sachs-warns-on-global-economic-slowdown.html

As Michael Pettis sums it up,

For the next several years, as Keynes reminded us in the 1930s, savings is not going to be a virtue for the world economy.  It is more likely to be a vice.  In order to regain growth the world desperately needs less savings and more private consumption, but I think it is not going to get nearly enough to generate growth.  Why?  Because in all the major economies the banking systems are largely insolvent, or about to become so, and desperately need to rebuild capital.  This will have a large adverse impact on private consumption.

With all of the major economies facing banking crises, they must clean up the banks by forcing the household sector to pay the bill.  This will put downward pressure on household disposable income and wealth for many years.  But we are all betting on the consumer – and inexplicably enough (to me, anyway) many of us are betting most heavily on the hapless Chinese consumer – to come surging back and bring us the growth that we so desperately need.

I am pretty skeptical that this will happen.

http://mpettis.com/2010/07/what-do-banking-crises-have-to-do-with-consumption/

'Austerity,' of course, means government saving. Consumers may still be in a spending mood in rapidly growing economies such as China and India. But together, China and India constitute only 10.6% of world GDP -- hardly enough to be a global locomotive.

If China can't save us, then who can? Over to you, Weimar Ben. Better wear your Lombard Street top hat, if you want to produce a magical rabbit from it.

"Oh, if we could but transmute lead into gold ..."

 

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Re: Financial Conditions: Austere

Some folks just don't get it, though. Europe seems determined to repeat the U.S. experience in the early 1930s:

July 5 (Bloomberg) -- The euro ended a three-day winning streak and bonds rose after European Central Bank President Jean-Claude Trichet urged “austerity” measures to contain budget deficits.

Trichet said yesterday he has “no problem with austerity, rigor” as “good budgetary management,” following reports last week that showed U.S. payrolls dropped for the first time this year and factory orders slumped.

The euro weakened 0.3 percent to $1.2533 at 12:34 p.m. in New York. The yield on 10-year German bunds fell four basis points to 2.55 percent. Crude lost 0.8 percent. The Stoxx Europe 600 Index lost 0.3 percent.

http://noir.bloomberg.com/apps/news?pid=20601087&sid=aQDd8zVrwmbk&pos=1

'Liquidate Ireland, liquidate Greece, liquidate Spain, liquidate Portugal ... it will purge the rottenness out of the system', counsels the ghost of Andrew Mellon.

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Re: Financial Conditions: Austere

Machinehead!  Dude, you are awesome!  I'm curious as to how you are so well informed.

Another question in regards to this note from Michael Pettis:

With all of the major economies facing banking crises, they must clean up the banks by forcing the household sector to pay the bill.  This will put downward pressure on household disposable income and wealth for many years.  But we are all betting on the consumer – and inexplicably enough (to me, anyway) many of us are betting most heavily on the hapless Chinese consumer – to come surging back and bring us the growth that we so desperately need.

 

I am pretty skeptical that this will happen.

So, if we're all betting on the consumer, the Chinese consumer, and we lose the bet, what then happens? 

 

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Re: Financial Conditions: Austere
earthwise wrote:

Machinehead!  Dude, you are awesome!  I'm curious as to how you are so well informed.

My guess that he's actually Ben Bernanke's integrity and conscience forced to express itself via a rebellious and anarchistic alter-ego that comes out when his conscious mind is asleep or unaware.  Picture Brad Pitt/Tyler Durden's face with the beard and balding head.

BTW, you REALLY don't want to know what he's been doing to Larry Summer's soupLaughing

- Nick

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Re: Financial Conditions: Austere

"Oh, if we could but transmute lead into gold ..."

So it could be worth a whole lot LESS....??

Mike

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Re: Financial Conditions: Austere
machinehead wrote:

"Oh, if we could but transmute lead into gold ..."

We could, but first we'd need to understand and replicate the process of a supernova. Of course if we could do that, fusion energy would be trivial and so plentiful that there would no need for the barbarous relic.

 

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Re: Financial Conditions: Austere
earthwise wrote:

Another question in regards to this note from Michael Pettis:

With all of the major economies facing banking crises, they must clean up the banks by forcing the household sector to pay the bill.  This will put downward pressure on household disposable income and wealth for many years.  But we are all betting on the consumer – and inexplicably enough (to me, anyway) many of us are betting most heavily on the hapless Chinese consumer – to come surging back and bring us the growth that we so desperately need.

 

I am pretty skeptical that this will happen.

So, if we're all betting on the consumer, the Chinese consumer, and we lose the bet, what then happens? 

Defaults. Some far-gone cases (e.g. Greece) are going to default anyway. But an extended period of global stagnation would start taking out bigger fish (Spain, UK, maybe even the US). 

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Re: Financial Conditions: Austere
nickbert wrote:
earthwise wrote:

Machinehead!  Dude, you are awesome!  I'm curious as to how you are so well informed.

My guess that he's actually Ben Bernanke's integrity and conscience forced to express itself via a rebellious and anarchistic alter-ego that comes out when his conscious mind is asleep or unaware.  Picture Brad Pitt/Tyler Durden's face with the beard and balding head.

BTW, you REALLY don't want to know what he's been doing to Larry Summer's soupLaughing

- Nick

Well that certainly explains things.

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Re: Financial Conditions: Austere

The Fed floats a trial balloon in the WaPo about a possible 'QE II':

Federal Reserve officials, increasingly concerned over signs the economic recovery is faltering, are considering new steps to bolster growth.

With Congress tied in political knots over whether to take further action to boost the economy, Fed leaders are weighing modest steps that could offer more support for economic activity at a time when their target for short-term interest rates is already near zero. They are still resistant to calls to pull out their big guns -- massive infusions of cash, such as those undertaken during the depths of the financial crisis -- but would reconsider if conditions worsen.

http://www.washingtonpost.com/wp-dyn/content/article/2010/07/07/AR2010070705100.html?hpid=topnews

This is exactly what I expected Bernanke to be thinking -- with the fiscal channel frozen, only the Fed has the flexibility to move quickly in addressing any fresh weakness.

After discussing 'baby steps' such as easier language ['zero percent forever!'], eliminating interest on reserve balances [so banks will prefer to lend more], and replacing matured mortgage securities in its portfolio, the article broaches the critical issue:

Fed officials do not rule out launching a major new asset-purchase program. Rather, they say they would consider one only if their basic forecast -- of continued steady expansion in the economy -- proves to be wrong. A key factor that would build support for new asset purchases would be a rise in the risk of deflation, or a dangerous cycle of falling prices -- which has become more of a concern as the world economy slows.

This is classic Bernankeism, to the point that I suspect he wrote it. Via an anonymous leak to the WaPo, Bernanke can both give fair warning of his intentions, as well as gauge political reaction. With 468 KongressKlowns and Senators facing re-election in November, I doubt many will complain at the prospect of more 'free money.'

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Re: Financial Conditions: Austere

George Soros diagnoses the European spectre haunting the global economy:

The situation is eerily reminiscent of the 1930s. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banking system and the economy may not be strong enough to do without fiscal and monetary stimulus. Keynes taught us that budget deficits are essential for countercyclical policies in times of deflation, yet governments everywhere feel compelled to reduce them under pressure from the financial markets. Coming at a time when the Chinese authorities have also put on the brakes, this is liable to push the global economy into a slowdown or possibly a double dip. Europe, which weathered the first phase of the financial crisis relatively well, is now in the forefront of causing the downward pressure because of the problems connected with the common currency.

A structural flaw in the euro is that it guards only against the danger of inflation and ignores the possibility of deflation. In this respect the task assigned to the European Central Bank is asymmetric. This is due to Germany’s fear of inflation.

The euro’s design does not allow for error. It expects member states to abide by the Maastricht criteria—which state that the budget deficit must not exceed 3 percent and total government debt 60 percent of GDP—without establishing an adequate enforcement mechanism. And now that several countries are far away from the Maastricht criteria, there is neither an adjustment mechanism nor an exit mechanism. Now these countries are expected to return to the Maastricht criteria even if such a move sets in motion a deflationary spiral. This is in direct conflict with the lessons learned from the Great Depression of the 1930s, and is liable to push Europe into a period of prolonged stagnation or worse.

Germany went into the G-20 meeting in Toronto on June 26–27 largely isolated. Before the meeting, President Obama publicly pleaded with Angela Merkel to change her policies. At the meeting the tables were turned. Canada’s Stephen Harper as the host and David Cameron, the newly elected Conservative prime minister of the UK, lined up behind Merkel, leaving Obama isolated. Supporting Merkel’s approach, the G-20 endorsed a halving of budget deficits by 2013 as the target. This has extended the threat of a deflationary spiral to the global economy, making the experience of the 1930s even more relevant than it was when I gave much of the preceding text as a speech at Humboldt University.

The political leaders claim to take their cue from the financial markets but they are misreading the signals. Sovereign risk premiums have widened in Europe because of the situation of the banks; but yields on the government bonds of the US, Japan, and Germany are at or near all-time lows, yield curves are flattening, and commodity prices are declining—all foreshadowing deflation. 

http://www.nybooks.com/articles/archives/2010/aug/19/crisis-euro/?pagination=false

What to do, what to do? Among other things, Soros concludes (as I do) that monetary policy must become more expansive to offset the fiscal stringency:

First, the current crisis is more a banking crisis than a fiscal one. It is clear ... that the banks are greatly overleveraged and need to be recapitalized on a compulsory basis.

Second, a tightening of fiscal policy must be offset by a loosening of monetary policy.

Third, this is the time to put idle resources to work by investing in education and infrastructure. For instance, Europe needs a better gas pipeline system, and the connection between Spain and France is one of the bottlenecks. The European Investment Bank ought to be able to find other investment opportunities as well, such as expanding broadband coverage or creating a smart electricity grid.

The danger here is that global efforts become wildly uncoordinated: Asia (China, India and Australia) tightening against inflationary pressure; the politically-frozen ECB standing pat as Athens and Madrid burn; while Ben Bernanke's dreams espy the outline of 'QE II' emerging from the mists of cloud-cuckoo land. 

Oh my, what a policy dog's breakfast! Surprised

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Re: Financial Conditions: Austere
Quote:

Germany went into the G-20 meeting in Toronto on June 26–27 largely isolated. Before the meeting, President Obama publicly pleaded with Angela Merkel to change her policies. At the meeting the tables were turned. Canada’s Stephen Harper as the host and David Cameron, the newly elected Conservative prime minister of the UK, lined up behind Merkel, leaving Obama isolated. Supporting Merkel’s approach, the G-20 endorsed a halving of budget deficits by 2013 as the target.

Quote:

First, the current crisis is more a banking crisis than a fiscal one. It is clear ... that the banks are greatly overleveraged and need to be recapitalized on a compulsory basis.

I have great respect for Soros' reading of global macroeconomics but I disagree with him on the above two points. The first is relatively trivial but it was clear from reading the pre-G20 reports that Obama was alone and the Euro zone was already embracing austerity.

True the banks are overleveraged, but I'd rather see them be allowed to fail and go through the unwinding and asset destruction to bring some forced sanity to the sector rather than a continual propping up by the public (government).  Allowing mega bank failures would inflict severe hardship but propping them up simply kicks the can of reckoning futher down the road.

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Re: Financial Conditions: Austere

Now the [U.S.-dominated] IMF weighs in on the potential need for monetary stimulus:

The International Monetary Fund has called on the European Central Bank to prepare fresh emergency action to stabilise debt markets, throwing its weight behind calls for renewed monetary stimulus to offset budget cuts.

While the IMF stopped short of calling for the ECB to launch full quantitative easing (QE), it is clearly worried that the bank's passive policies have allowed credit to wilt and led to fresh strains in interbank lending markets and sovereign debt.

The ECB has so far purchased €59bn of Greek, Portuguese, Spanish, and Irish bonds, but has sought to drain any stimulus through "sterilisation" operations.

With German industry was booming, ECB president Jean-Claude Trichet said there is no risk of double-dip recession. "I see perhaps a tendency from the outside to be excessively pessimistic. The numbers we have are not confirming this pessimism," he said.

The IMF's implicit criticism comes amid press reports that the US Federal Reserve is drawing up plans for fresh monetary stimulus in case recovery stalls, including more bond purchases. The news story has been widely seen as "kite-flying" by doves on the Fed Board to test the response to a fresh burst of QE.

http://www.telegraph.co.uk/finance/economics/7880333/IMF-tells-Europe-to-inject-more-stimulus.html

Everything points to a split between the inflation-fearing ECB and the deflation-fearing Federal Reserve. 

Normally my sympathies would lie with the ECB. But the Greek crisis has not been properly addressed, only papered over temporarily. Meanwhile, severe fiscal tightening heightens the risk of a double-dip recession in Europe.

The ECB needs to stay flexible, since the euro's structural problems have not been fixed, and are likely to bite again soon.

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