1. What Did Bernanke Say?Speaking at the Kansas City Fed's annual symposium in Jackson Hole, Wyoming, Federal Reserve Chairman Ben Bernanke reassured financial markets that the "Bernanke Put" remains in place, ready to limit damage to consumer spending and economic growth from a deepening housing recession.
2. What is the Primary Concern?-Having done that, here are some important takeaways that we see.
-First, remember all that stuff about subprime mortgage issues being "well contained"? Well, that was wrong.
-"The financial turbulence we have seen had its immediate origins in the problems in the subprime mortgage market, but the effects have been felt in the broader mortgage market and in financial markets more generally, with potential consequences for the performance of the overall economy," Bernanke said.
-What happens when risk aversion grows?
-The velocity of money slows.
-In other words, the key engine of the economic growth begins to sputter.
-"More generally, investors may have become less willing to assume risk," Bernanke noted.
Of course, the role of the Federal Reserve as it is seen from within, is to push risk assumption without letting it get too carried away.
-"Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time," Bernanke acknowledged. "However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress."
-In other words, risk aversion has spilled over into credit markets generally, which threatens the whole economy.
3. Anti-Deflation Round 1: Coordinated Fiscal and Monetary Response.- On Friday, President Bush just concluded a speech announcing the first stage of Federal help for subprime borrowers.
-This is not a "bail out" of borrowers and speculators President Bush said.
-Indeed it is not.
-Bush will "let" the Federal Housing Administration guarantee loans for subprime borrowers, allowing them the avoid foreclosure and refinance at more favorable rates, but as with all things there is a price.
-In other words, the move is to help guarantee payments to lenders.
-The irony?
-The fiscal response illustrates what is really going on behind the guise of "bad" subprime lending.
-Nobody wants these homes because they aren't worth what was paid for them.
-The borrowers would rather walk away than service the outrageous debt to value ratio.
-And the last thing the lenders want are homes that they are unable to sell.
4. It's a Series of Events, Not a Process.
-What about financial markets? Shouldn't they go down if they are really on their way toward a full scale deflationary credit crisis?
-Remember, the end of this credit cycle is a series of events, not a defined process. What do we mean by that?
-If we do fall into a full-scale deflation, it will eventually look like this: Stocks decline, interest rates move lower, bonds move higher, yet the dollar goes up.
-Only dollars can pay down debt, so they become more valuable.
-That is why the dollar can go up if deflation is at hand even though the central bank will be trying to fight it by lowering the cost of borrowing money.
-But by that time, deflation will be front page news and, almost by definition, any fiscal and monetary response will be too little and too late.
-But this is a long-term series of events, not a domino process, and we are just now entering the first round of policy actions.
-That makes it difficult to understand why markets may continue to go up for a while.
-Narratives are linear by design.
-Scenes are set, characters identified and defined, actions unfold over time in steps that lead toward a resolution.
-Unfortunately, while narrative is convenient in helping us understand things, it is useless in predicting how things unfold. Why?
-Because history does not unfold in a linear manner.
-Man, in retrospect, it all seems so clear. Have you ever thought that? I have.
-But why? Why does everything seem so clear in retrospect?
-Because we are hardwired to recount events in linear narrative fashion... even events that do not unfold in a linear manner!
-In other words, our need for linear narrative colors our perception of history.
-Linear narratives unfold in steps, the output proportionate to the input.
-The Federal Reserve Chairman lowers interest rates, the first a surprise 50 basis point cut, for example.
-The stock market rallies.
-Money is less expensive, so people borrow and put that money back into the stock market, or in houses.
-It certainly seems that way.
-However in reality, in non-linear systems, the output is not directly proportional to the input.
-So it's not the case that if, say, the Fed does X, a proportional outcome will follow, or if the Fed and politicans implement Y, a series of proportionate outcomes will follow.
-On the one hand, this is why it is so very easy to sit back and laugh at the predictions of economists and market strategists.
-Ha ha, the one prediction that is sure to be guaranteed proven correct?
-That their predictions will most likely be wrong.
-But this is not about "predicting" deflation.
-It's about discussing the most probable outcome of central banks continuing policies of attempting to maintain continued credit expansion.
-As long as credit expansion and demand for credit continues at an accelerating pace, the appearance of prosperity continues as asset prices increase.
-The one thing we do know, is that this credit expansion has a price.
-It must one day be repaid.
-How that day arrives is anyone's guess.
-But the longer it is delayed, the more painful it will ultimately be.
