Financial Market Logjam Not Over

October 14, 2008

The framers of the latest barrage of measures to unfreeze global credit markets are asking investors for patience, conceding a difficult recession ahead and that current banking system problems will not go away overnight. Deep down, investors are unconvinced.  Trading was disappointing in the first U.S. session since the G-7 weekend meeting and the unveiling of broad initiatives from the United States and numerous other governments.  Libor premiums over overnight central bank target rates stayed almost as elevated as such were before the weekend.  The Nasdaq slumped 3.5%, while the DJIA and S&P 500 lost 0.8% and 0.5%.  The yen, which had climbed from 149.6 per euro when Lehman failed last month to a high of 132.26/euro last Friday, fell back to 141.72 in Asia but strengthened anew to 138.9 per euro during the U.S. day and to 101.5 against the dollar.  Officials are believed to have hoped that the yen would settle back to 105/$ on a lessening of extreme risk aversion.  One lesson from today is that financial market sentiment remains more predisposed to pessimism than optimism.  Professor Nouriel Roubini is one of the most respected economic bears these days, so markets paid keen attention when wire service headlines reported his new prediction today of the worst recession in at least 40 years, just as market euphoria in the late 1990’s tended to get a boost every time analyst Abby Joseph Cohen, the most bullish prognosticator of that era, would release a new forecast.

U.S. and G-7 officials have been praised for recognizing the severity of the financial risks and taking action to recapitalize banks faster than Japanese officials did last decade.  Nonetheless, the approach has been incremental and not responsive enough, as attested by the festering and deteriorating evolution of the banking crisis.  None of the steps prior to the latest  proved sufficient.  A separate problem has its roots in the ultra-easy Fed policy adopted after 2000.  The remedy for a bursting dot-com bubble created an even more dangerous housing bubble.  Monetary policy was calibrated to prevent a Japanese-like deflation in the United States, but the U.S. economy became addicted to extremely loose credit policy.  Officials knew the risks of breaking the habit cold turkey and chose to wean the economy predictably and very gradually over the two years to mid-2006.  The housing bubble burst in spite of such caution, and rates seem headed to their 2003 lows and perhaps to a quantitative easing like Japan had for the five years to early 2006.

One can only hope that Japan’s example is not completely copied in the United States.  The last time the Bank of Japan target overnight rate was higher than its present 0.5% was over thirteen years ago.  Japanese real GDP expanded at an annualized rate of only 0.9% for the 11 years between 1Q91 and 1Q02.  A multi-year L-shaped recession is the scenario that Professor Roubini now projects.  After recapitalizing its banks, Japan managed to lift economic growth to 2.3% per annum for the five years to 1Q07.  While more than twice as fast as before, 2.3% is only a shadow of the kind of growth that Japan routinely experienced prior to 1991.  And growth of 2.3% was achieved only by keeping nominal interest rates extraordinarily low.  A second major lesson from Japan is that in a multi-year period of sub-trend growth, deflation can take root.  Even with growth averaging above 2% per annum over five years and a predisposition by monetary officials to restore normal interest rates as soon as possible, the BOJ Policy Board was unable to raise interest rates higher than 0.5%, and that level is clearly too high in present circumstances.  The final lesson, therefore, is that a multi-year recession can render monetary policy powerless to handle future business cycles. A danger exists that fall-out from current banking system problems may still be felt in 2020 or later.

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One Response to “Financial Market Logjam Not Over”

  1. Tom Rispoli says:

    Tommy McCall did a some research comparing presidents and S&P growth. He came to the same conclusion as you did. He got paid for it though. It’s in the opinion section of the NYT, “Bulls, Bears, Elephants and Donkeys”.