Monday, October 6, 2008

More good news

About 15 minutes after my last post, stocks mounted a roaring comeback, reversing about half their losses. I'm not sure why, but I've learned to never underestimate the power of the Fed. They have been hard at work reliquifying the banking system, and the surge in reserves I noted awhile back was the first sign that they were gaining traction. The decline in short-term swap rates was another sign.

As of today the Fed starts paying interest on the reserves that banks hold at the Fed. That makes it easier for the Fed to expand the money supply. Why? Because in the past if they added reserves to the system by buying other assets, they would have to take offsetting action to drain reserves in order to keep the funds rate at their target. If they added too much money then the interest rate on reserves would fall, because, since banks don't earn interest on their reserves it's equivalent to a tax, or opportunity cost, they would dump any excess reserves back into the market, depressing the funds rate, and requiring the Fed to soak them up. Now that won't be a problem (well, it will actually be less of a problem, since the Fed may not pay the same rate on reserves—probably less—as the rate of their Federal funds target).

So now they can pump in reserves easier, and extra reserves will go a long way to assuaging fears of bank failures. Eventually those reserves can translate into more money for the economy, and that's apparently just what the economy wants and needs at this point. We'll worry about the inflation implications of this later. But for the time being I wouldn't get caught up in the popular notion that our biggest threat here is one of deflation.

19 comments:

Tory Conservative said...

I sure hope the stock market has bottomed out now. I have an investing time horizon of about 20 years. So, I'd to see this thing turn around. And I'm still 100 percent in stocks. Oh, well. Too late to change asset allocation now.

Scott Grannis said...

I with you 100%. The only reason to sell now is if you are convinced that the world as we know it is coming to an end and things won't be right for many years to come. I can't see that, which is why I'm sitting tight. This is not the time to be selling.

As Warren Buffet says, "if you like hamburgers you should be thrilled when their price drops, because then you can buy more." He does get some things right, even though he is dead wrong on taxes.

pcpb participant said...

a. How is he dead wrong on taxes? (I'm not up to date on the news.)

b. What is your reaction to the wsj comment by z. Karabell today?

Scott Grannis said...

Warren has endorsed Obama's call for higher taxes on the rich and on capital (e.g., raising the capital gains tax and dividend tax). I think that's very bad policy. Higher tax rates do not guarantee higher revenues, and they can discourage capital formation and work effort. I believe in the Laffer Curve. Best is to have a low flat rate with no deductions.

d said...
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d said...

i was a bit nervous myself this AM, but i figure you really have to have the stomach for these types of moves. feels like the bottom to me. pretty impressive move at the end there.

pcpb participant said...

Actually, to be a devil's advocate, some people have no job, just money. Seems a tax on the gains of their investments could be seen as a legitimate form of income tax.

Obviously the capital they invest may lead to tax paying enterprise. We all know that a penny saved is a penny taxed twice.

But if we're going to fight wars and pave our streets, ...well it's all about more money.

This brings us back to the wsj column by Zachary Karabell. Your reaction to that?

Scott Grannis said...

I've been through a lot of crises and panics, and the bottom usually coincides with a powerful sinking feeling in my stomach. It keeps getting worse until I'm kicking myself for having been so stupid as to not have sold a long time ago.

Scott Grannis said...

Taxing capital and dividends at all is bad policy, because we end up double and triple-taxing the money that people save. Saving and investment provide the basis for growth since they give us productivity enhancing tools, new plant and equipment, etc. We are stupid to penalize these activities.

The big reason we have a deficit is not because of a shortfall of tax revenues (which today are about average relative to the size of the economy) but because we have an excess of spending.

pcpb participant said...

True, excessive spending, ...relative to the size of the economy, of course. (This is verging on a truism tho.)

Of course, for some people the economy IS what the govt. spends. Just listen to all that "Obama-speak."

But, how do we "grow out of our troubles" this time if we are not as competitive with, say, China as we were last time?

(I'm thinking of the Carter presidency and double digit inflation we grew out of then.)

Scott Grannis said...

International trade is not a zero sum game, it's a win-win for everyone. We don't have to fear China and in any event we don't compete with China on that many fronts. They have cheap labor, we have very smart labor backed by highly efficient capital and infrastructure. We have very efficient markets (most of the time), their markets are still evolving. As China moves rapidly up the economic ladder we will find all sorts of new ways to trade with them. Their prosperity will be reflected in our prosperity; the more they earn the more they will spend.

Don't underestimate our ability to grow and leave our problems behind.

CDLIC said...
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CDLIC said...

Scott:

Do you favor a flat tax over a consumption tax: if yes, why?

While on he issue of taxation, one of my favorite quotes on the subject is by Jean Baptiste Colbert (French Economist and Minister of Finance under King Louis XIV of France. 1619-1683):
“The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing”

If Obama becomes President and his tax-plan materializes to tax capital, dividends, etc., there will be much hissing -- and eventually fewer geese to pluck (thank you Mr. Laffer).

CDLIC

Scott Grannis said...

There are many excellent arguments in favor of a consumption tax, but I would prefer a flat income tax. Modifying the current system may be easier than shutting it down completely and starting up a new one.

pcpb participant said...

"International trade is not a zero sum game, it's a win-win for everyone."

Tell that to the Chinese, ...or to the Russians.

It's win/win if THEY see it that way. As they hold the gold, they make the rules, ...or could if they choose. Seems to me that the good, ole, USA is quite vulnerable at the moment and that our investment outlook should reflect that.

What do you think of Peter Schiff?

Scott Grannis said...

If we are vulnerable then the Chinese are doubly so. Most of their trade surplus with us was invested in our treasury bonds. The dollar is now worth less in terms of their currency than when they bought our bonds. They own almost a trillion dollars worth of bonds that have gone down in value. They are vulnerable to losing a fortune if our economy tanks. Plus, they could lose our demand for their goods if we tank, and that represents a big part of their success. Foreign trade creates strange bedfellows; we both need each other. No one obviously has the upper hand.

pcpb participant said...

It's a different story with Russia and their oil income, and their belligerent DNA.

Peter Schiff?

Scott Grannis said...

You're right, Russia is a different and worrisome story. As for Peter Schiff, I haven't seen his stuff, but I understand he's from the Austrian school of economics. I think the Austrian's notion of the business cycle is in need of updating. Financial markets and monetary policy work very differently today compared to just a three or four decades ago. Just think of how fast information is disseminated these days. That helps markets fix themselves better than almost anything that existed before my time.

pcpb participant said...

For Peter Schiff look up Euro Pacific.

Your reaction to his philosophy would be very interesting, probably enlightening, and of value.