just in in-tray, but of course the bit about gold is symptomatic of american academic ignorance regarding gold and steadfast inability to recognize that, this time, the tsunami starts and will finish at the center
A good friend of mine is the Dean of the Business School at the University of xxxxx and he passed this along from his Finance Chair....
About eight months ago I estimated (back of the envelope calculation) that given the amount of loss of equity in financial system the total credit contraction in the US financial system would be about $7 trillion dollars with a range of error between $5 (low estimate) to $10 trillion (high estimate). The size of this is about ½ of year of the US GDP which puts it in perspective in term of the impact on the economy. I shared this estimate with you back in August along with my 402 Fixed Income class.
The only real hope of the TARP plan was to "recapitalize" the financial system by direct equity injections. I estimated that it would take (in round figures) about $1.5 Trillion to avoid this massive contraction and said so publically at the time on a few TV news programs. (ABC news just called asking me to discuss this on the air today, recalling that I said a few months ago the TARP was too small). Unfortunately TARP has now maxed out at $350 billion (not including the action today with CITICORP, holding the other $350 billion for the Obama administration); but it has been used more wisely by equity injection rather than by asset purchase. However, this left the Fed with the responsibility to try to shore up the system because the equity injection was far too small to offset the credit contraction in the capital markets.
The only option left to the Fed was to intervene directly in the capital and banking market and directly and indirectly take this debt on their balance sheet. They have done so direct action of either buying or guaranteeing debt. With the expansion of the Fed balance sheet and the extension of guarantees, we have now reached the $7 trillion mark. Unfortunately, because the cleaner option (sufficient equity injection) was not taken, we now may see the contraction exceed the $10 trillion mark and even more on a global scale. We are still left with a greatly weakened financial system that cannot hold the nominal (face)debt claims of the economy.
Many financial observers incorrectly assume that this expansion of the Fed's balance sheet will be highly inflationary and cite the high sustained gold prices as evidence to support this claim. If these were normal times, I would tend to concur with this conventional view. However, this ignores the massive deflationary effect of the contraction of credit extended in capital markets. The Fed action is just a partial substitute for credit not being extended in the rest of financial system. If effect, the money supply is contracting far faster than the Fed can reasonably and responsibly act. This is why I have not been concerned with inflation in the near term.
Even in the longer term, I am nearly certain that we will see a big shift in the behavior of households and businesses in their use of debt. Of course, as consumers globally try to save or pay down debt, they will spend less out of current income, and with their recent experience of losses in all asset classes in the markets, they will also demand a bigger premium for risk for all assets classes. This added liquidity will be used to build back savings and is unlikely to causes inflation in the longer term as well. We are seeing deflation being priced into the TIPS (inflation protected treasuries bonds) for as long as 10 years out and about 1% inflation over a 30 year horizon. IF deflation gets out of hand, we will be in very serious trouble.
The reason gold prices remain high is because in developing economies there is a real fear of collapse of their very fragile financial systems and physical gold is good hedge if this happens. Note that only physical gold works here and not gold mining stocks. This is why we see the disconnect between bullion and gold mining stocks and the other complex of hard commodities. This is also why we are seeing the Yen and Dollar do well against other currencies.
The net effect will likely be the following:
1. Consumer lead economic recovery is a thing of the past. Consumers will not spend us out of recession.
2. These cutbacks will have long lasting effects on employment. Not only will unemployment be relatively high, the rate of recovery will be slow even as we move out of recession.
3. Fiscal stimulus will be the only path that leads to a significant recovery. The real choice is how this takes place.
a. One plan is to spend on infrastructure as China has proposed. This is straight out of the playbook of lessons from the great depression. Unfortunately, while this may be useful (these projects may create net wealth) it will not work as well as hoped in the US because our economy has changed so much over the last 70 years. In the 30's we had specialized physical capital (factories)and non-specialized labor (semi-skilled workers) idle because of the depression. Public works projects could employ productively this semi-skilled labor. With the multiplier effect, their consumption expenditures stimulated demand across the board. By contrast this major recession releases far more specialized labor and far less specialized capital. Public works cannot productively use this labor since their human capital is so mismatched to the jobs. We would suffer a huge opportunity loss by expecting this to work.
b. A Better plan would be to stimulate the economy by cutting the corporate tax rate to 0% and not changing any other part of the tax code. Cuts in individual income taxes will help little. Of course a 0% corporate rate is not politically possible, but a huge cut in the rate to say 10% might be possible. I think the private sector could absorb the specialized labor if we taxed the most productive parts of the economy less. In the short run, business would pay down on debt with this cut, thus taking some of the burden of the Fed. With time, and easing of the credit contraction, consumer and business confidence would recover and productive employment along with it. This second option would take at least two to three years to show results.
c. We will see which of these get adopted, but I am betting on variations of a. over b. If so, we will be on a path to slower growth that we would have under b and likely a few years to dig ourselves out of the hole. The real worry is that the size of this may now kill confidence in the banking system just at a time when it was turning around.
Best Regards,
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