Liquidity trap (ein langer Text auf englisch)

DT , Samstag, 09.02.2008, 13:36 (vor 6561 Tagen)

Man soll die Geschichte anschauen, um daraus zu lernen, und um sie nicht wiederholen zu müssen.

Gerade die Zusammenhänge, die schon Ende der 90er Jahre zu Domino-Effekten geführt haben (gleich im ersten Kapitel) sind hochinteressant.

Man kann also nur dazu raten, bei noch weiteren Spikes im Ölpreis das Brent massiv zu shorten.

Wenn damals schon aufgrund der emerging markets (das waren damals die Tigerstaaten Indonesien, Malaysia, etc) das Öl auf $8 fiel (allerdings nicht von $100 kommend), dann frage ich mich, was in der bevorstehenden WWKrise passieren wird.

DT

Liquidity Trap, long
Well written, comprehensive piece. I pasted it here but it reads much better on his site.

http://people.internet2.edu/~ndk/trap.html

Liquidity Trapped
"It" is happening here again

Long real interest rates in the U.S. are failing to respond to the dramatic lowering of short-term interest rates by the Federal Reserve and the use of frequent, large TAF injections targeting troubled banks. This cuffs the Fed's ability to control the damage in the credit markets and the credit destruction it's causing.

magwitch@gmail.com for feedback. This is an unmarked mix of interpretation and actual facts. Treat everything as malarky and do your own research. If you already know the lay of the land and just want my interpretation, skip to #2, please.

1. How we got here
1a. Bahtulism & LTCM
1b. Making sure "It" doesn't happen here
1c. The deep end
1d. Circles
2. "It's" happening again
3. So WTF is a "liquidity trap"?
4. How the do we get out of it?
5. Conclusion

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1. How we got here
a. Bahtulism & LTCM
The current "subprime" crisis is actually rooted in the crisis that ripped through Asian economies in 1997. In the Asian Financial Crisis, sometimes known as the Asian Contagion or Bahtulism, many countries in Asia suffered a simultaneous economic crisis in that year due to a severe capital flight. There had been large speculative inflows into the countries pursuing the high growth and interest rates available. This created a large amount of credit and leverage in the domestic economies, propping up real estate values, capital investment, and growth rates. The punch turned sour when hot money flows abruptly reversed and it was discovered that the markets, while wide open to foreign investors, weren't nearly deep enough to accommodate the inflows. Investors simultaneously tried to withdraw and convert a large amount of this credit in the context of a currency that was pegged too high for underlying economic fundamentals.

The relevant countries in Asia learned several handy lessons through a large amount of economic pain:

Never attempt to peg your currency higher than economic fundamentals permit or you can defend;
Only borrow in currencies that you control;
Capital controls prevent herding;
Never, ever listen to the advice given out by someone wearing an IMF name badge touting structural adjustment.
Britain went through a similar attack on their pegged currency just five years earlier, but the inflow of speculative money into Asia was more caused by their apparent high growth and real interest rates due to mobilization of large labor forces and less George Soros, despite the claims of some ministers. China emerged notably well, not forced to devalue due to their capital controls. They committed to their currency peg, no matter the prevailing economic conditions, until 2005 brought small reluctant changes.

The decline in emerging economies also led to a strong negative demand shock for oil, which bottomed at $8 in 1998. That hurt most oil exporters, including blowing up Russia, and led directly to LTCM's demise. That was actually a relatively minor and brief event of illiquidity compared to the current magnitude of events. Banks were arranged under the auspices of the New York Fed to assume the positions of the capital-impaired hedge fund, and crisis was averted by selling off LTCM's assets and liabilities. The trades actually did net out to a small profit in the end.

Investors and regulators both learned important things from this disaster too. The investment community figured out that too big to fail and a Greenspan Put, giant tooth fairies, existed. The government didn't take its lender of last resort functionality lightly. Regulators learned that they were able to clean up in the aftermath of most any crisis -- after all, how much bigger than LTCM could any investor get? They were the behemoth of behemoths.

Crisis averted, the brief cut in interest rates in the U.S. flamed the incipient the dot-com bubble. You know all about that.

b. Making sure "It" doesn't happen here
The spectacular collapse of the NASDAQ and S&P, along with the incipient wealth effects and low prevailing interest rates at the time, led to a real concern that we were repeating the experience of Japan. This experience has involved protracted economic slump, random periods of recession, and a steep deflation in the overall money supply. Prior to Japan's collapse into that morass, we didn't really collectively believe it possible in the modern era.

The Federal Reserve studied Japan deeply, fearing a similar turn of events in the U.S. The primary conclusion was that liquidity traps were something that should be broken before they had a serious grip on the underlying economy. This is most famously recorded in a speech in which "Helicopter" Ben Bernanke, then a member of the FOMC and now its chairman, earned his moniker.

Monetary policy would be unusually stimulative and aggressive. Most importantly, there would need to be a credible commitment by the Fed that its accommodative stance would be maintained indefinitely, even after recession had long since been broken. Check the statement language from the time: they stated and delivered exactly that commitment.

Short-term rates were slashed dramatically, left at 1% for an extended period of time, and were only increased in measured .25% steps through a relative maximum of 5.25%.

c. The Deep End
There are four particularly fascinating things about the normalization of interest rates and the resulting plateau.

Long-term expected rates of inflation, as measured in 10-year TIPS, absolutely failed to increase. They also failed to decrease. In fact, they remained fairly stubbornly anchored at around 2.5% throughout the entire episode, where they remain today.
Long-term nominal treasury rates in general failed to change very much.
Financial engineers got creative and the price of risky longer-dated debt soared, causing the yields to drop.
The dollar trended down throughout the entire period against most major currencies.
What would cause such a strange confluence of events? Alan Greenspan summed it up in a single famous phrase, as he was wont to do: a conundrum. Despite the wide swings in economic growth and interest rates on the short end, long nominal interest rates and inflation rates failed to change much. The long bond never decreased much below 4%, save for a couple months in '03 and the present, and never really climbed much above 5%. In particular, long-term interest rates failed to increase despite the series of hikes in the FFR.

He and his policies have been the subject of a phenomenal amount of vitriol. However, his mere need to publicly baptize the conundrum only gave name to a large body of evidence. The Fed almost completely lost control of the long end of the curve, and hence the interest rates that are most important when determining spending, lending, and investment decisions. They did utterly abdicate regulatory responsibility, which was in retrospect a big mistake, but their monetary policy was almost completely futile in both directions.

This was mostly due to the widespread implementation of anti-Bahtulism policy by the Far East and the oil exporters creating too much saving and pegging currencies at exchange rates far below what any real economic fundamentals warranted. They achieved this by forcibly printing and selling their own currency to buy mostly the dominant U.S. dollar. The excess money they created in their own countries through this process had to be sopped up, so they issued a large number of sterilization bonds. They also had to do something with all the dollars they accumulated, since it'd be a waste to leave them sitting around to rot under the indefatigable forces of time. These proceeds were invested in very safe, prudent places, like U.S. agencies and treasuries.

d. Circles
As Asia exported more and more goods to the U.S., and later to the Eurozone, the sums involved in this intervention grew titanic. Oil exporters, rolling in dough from the high price of oil resulting from constrained supplies and large and growing demand, reinvested the proceeds into the U.S. as well. Japan contributed by keeping its interest rates low and causing capital flight of its enormous savings through the carry trade. All this investment led to rapid growth in the U.S. economy. Further economic growth increased the size of the recycling flows and resulting investment. It was a big, beautiful capital circle that, because of feedback loops and currency pegs, never shrank.

Real interest rates in the world were dramatically depressed by the flood of forced investment resulting from this recycling of capital. Oil reserves and the savings of Chinese peasants were mobilized to feed the enormous financial machine. As more and more official investment crowded into the safest investments, driving down long real interest rates and stimulating the economy, yield-hungry private investors spread their money out and found the risks in doing so were greatly exaggerated.

Interest rates and risk spreads were both particularly compressed in the U.S., home to an extremely lax regulatory regime and creative and powerful financial system. Asia may not have been able to effectively invest all these proceeds, but our securitization engines certainly could.

Many Western economies and individuals had a perfectly rational response to this powerful economic message: they stopped saving, and they invested all they could using these cheap interest rates. Trouble is, there was a simultaneous flood of cheap goods and labor from China, India, and particularly in the U.S., some illegal immigrants from Mexico. This transmuted the investment message to focus largely on non-tradeables and consumer spending, contributing to our current surplus of houses and personal trainers.

Many commenters have expressed a belief that these recycling flows were responsible for propping up the U.S. dollar during an extended period of profligacy by Americans. Maybe. I instead believe that the U.S. dollar was actually driven down by this process. By definition, there could be no adjustment against these pegged currencies, and U.S. real interest rates were very low. Investors like high real interest rates because they make a lot of money. Currencies that could adjust did so in an expected way, with private investors diversifying for better returns abroad and dropping the value of the USD to the point where we all make Bundchen jokes.

2. "It's" happening again
Something started blowing up around late December of 2006. Deterioration was being seen in some narrow spectrum of U.S. housing, which had failed to appreciate much beyond levels reached in mid-2005. Income levels and creative borrowing couldn't sustain further expansion in the sector, and the first, weakest borrowers collapsed under the pyramid's weight with the announcement by HSBC that it would be writing down some investments. Some cleverly named Bear Stearns funds exploded. You know this part of the story well, so I won't bore you.

Credit spreads on mortgages have blown out, followed rapidly by spreads on virtually every other kind of debt. Short treasury yields plunged in anticipation of massive Fed intervention, which we've received some of, and long treasury yields dropped as well, but not by very much.

Commodities have continued to explode upward. A lot of you believe this is the result of an enormous increase in incipient inflation. You might well be right, but only if you're talking about inflation in the economies that had been saving money for us. China's inflation rate has indeed soared, and the inflation rates in certain sectors of the U.S. economy are also very high. However, the inflation rates in other sectors, and for wages in particular, is still very low. It could just be residual velocity from the massive money recycling engine we had, and it'll take awhile to slow the thrust despite being out of fuel.

Long-term interest rates are composed of three components: the risk of the security, the expected inflation rate over the term of the security, and the expected real return over the term of the security. Treasuries are (srsly) considered riskless investments from a USD perspective, so that's not an issue. We see absolutely no increase in the inflation rate as recorded in TIPS which still suggest around a 2.3% 10-year inflation rate. If you just believe those are mispriced, pour in your money.

That leaves the real interest rate. I believe it's been rapidly increasing. The huge recycling flows that China, the carry trade, and the oil exporters were powering have all slowed along with U.S. economic activity. With a likely decrease in imports from China at a higher RMB price, a smaller real interest rate differential, and somewhat lower oil prices and slightly less oil purchased, there just isn't as much excess savings being recycled into the world. To be fair and fairly ominous, even now these are still enormous numbers.

Long bonds haven't been responding quickly. There's less money around for investment. Real interest rates rise naturally and dangerously in response. If this is allowed to persist in the current environment, it would be a Louisville Slugger to the face for the real estate market.

Call our new world a sort of reverse conundrum, if you will: the Fed has been trying to get long-term real interest rates to drop, but it's been proven impotent again. Stiglitz calls it a "liquidity trap."

3. So WTF is a liquidity trap?
Japan's collapse involved something called a liquidity trap, long presumed to be extinct due to the advances in macroeconomic policies and a relic of bad models and policies in the '30's. Japan is living evidence that deflation is no relic, though, and even measures like quantitative easing were unsuccessful in reinflating their economy.

A liquidity trap is a situation in which economic policy is ineffective in changing real economic activity. Monetary policy, which usually works through increasing economic activity and consumption, is ineffective. Fiscal policy might be effective depending on Ricardian equivalence. There are a lot of economic food fights on this topic.

This is the second incipient liquidity trap since the Great Depression. The first was in '02-'03, and we broke it.

4. How do we get out of it?
We don't follow the IMF's structural adjustment advice, as pointed out by billions of smiling people in Asia and Latin America. We prevent capital destruction and promote counter-cyclical policies. Better yet, current account surplus countries like China unpeg their currencies and boost domestic spending. However, it's going to be really hard to effect these policies.

The process of preventing capital destruction by saving banks that did stupid things is well underway. This is being done through a combination of under-the-table loans, like FHLB's charity for Countrywide, and the TAF, which was a brilliant move. However, that only addresses the illiquidity issues, as Roubini is so fond of pointing out. Our fearless regulators are rumored to be haggling over who gets to claim credit for bailing out foolish bond insurers, though I think it's spurious to assume this will be as easy as saving the world from LTCM. There are a lot of utterly insolvent players.

Counter-cyclical policies are also needed. Although we've already started to enact them through interest rate cuts, the TAF, and the $150B check, we had two things in our favor in '02-03 that we don't have today.

The Federal Reserve made a credible commitment to an irrationally loose monetary policy back then. This commitment worked too well. The inflation mostly occurred in parts of the economy most affected by an increase of the money supply and further clobbered the vulnerable tradeable sector.

In fact, it worked so well that it turned you all into inflation hawks that are watching its every move despite persistently low long-term inflation rates. Listen to the din. We are now all glaring at the Fed, accusing it (probably accurately) of targeting asset prices, and we're having a tough time deciding whether it's a threat or a menace. They will have an extremely difficult time repeating this act without much of the money pouring straight into commodities and capital flight, which is counterproductive at best.

There was a persistent recycling of capital flows by China, the oil exporters, and the carry trade into long-term securities. These have waned, as they must for there to be any long-term sanity. With all three of these now facing their own sustainability issues, it's unlikely they'll jump into the breach as a monetary transmission mechanism.

The most severe danger right now is actually a sustained rise in U.S. interest rates and the dollar, which would further detonate risky credits and destroy more money, setting off a self-reinforcing debt-deflationary spiral. As savings from the money recycling engines fades, it's being replaced by a loud message to American entities to save more good cold cash. If you listen, you'll fare comparatively better. If we listen, we're hosed. Remember that the Fed exists largely to fight your rational impulse on this matter.

I don't think we can repeat this feat with our further increased debt loads and payments, further decreased savings rate, and balance of payments. However, key differences from prior capital flights, such as our debt and expenses being USD-denominated and our existence as the world's economic superpower with the primary reserve currency, mean we've got something other than Bahtulism.

The rest of the world, heavily dependent on these capital flows and the U.S. consumer from the other end, is probably in worse shape. Decoupling is a really novel idea.

5. Conclusion
The current situation is the confluence of all-too-rational reactions by a set of uncoordinated economic players. Everyone made the decisions that seemed the best from their perspective at that point in time, and those decisions have converged into today's issues. If there is no cooperation at this point, we're probably in for a long period of USD appreciation relative to other currencies and increased real interest rates.

Whether inflation rises and assets increase in value is a question of the policy response, but given how everyone feels about the $150B peanuts-sized stimulus plan and the cuts already undertaken by the monetary authorities, I don't think they dare do too much more. Simultaneous rapid rate cuts and speeches about their own credibility in recent weeks are evidence of fear, indecision, and probably an intractable problem.

I'm very glad we have Ben Bernanke and his fellow members of the FOMC at the helm along with all the excellent Fed economists. I wouldn't want to be in their shoes.