Monday, October 13, 2008

Capitulation and other signs of a bottom

I’ve seen lots of economists throw in the towel in the past few days. They’ve all succumbed to the dreadful panic that has gripped the markets this month. There seems to be almost universal agreement now that the economy is in a recession, and that it could last for at least six months.

I’ve been arguing the opposite, and I’m not throwing in the towel.

Yes, financial market conditions have been absolutely awful, the worst we’ve seen since the Great Depression. But that doesn’t mean a recession is a sure thing. Financial markets today are wonderful shock absorbers for the real economy. Extreme pain has been registered on the financial Richter Scale, but nothing significant has hit the economy yet. I’ve posted plenty of charts here that suggest that at worst we are only in a mild recession. At best, we’re in a period of slow growth.

Ever since I started this blog, on Labor Day weekend, I’ve been pointing out the fallacy of the doom and gloomers. The signs of recession are not convincing. This is not a credit squeeze or a credit freeze: bank lending continues to expand, and all measures of the money supply are at all-time highs. We have an abundance of money, but a shortage of buyers. This is not your typical recession.

Every recession we’ve had in modern times was caused by a major tightening of monetary policy. Money became very expensive and thus very scarce, and this forced the economy and the financial markets into a wrenching adjustment. This time we have had very easy monetary policy for most of the past several years. (Indeed, easy money was one of the major causes of the housing bubble.) There were so many dollars in the system that the dollar’s value recently fell to an historic low relative to other currencies, relative to gold, and relative to commodities.

This financial panic was not brought on by a monetary tightening. The trigger was a significant decline in housing prices and widespread defaults on subprime mortgages. It’s been exacerbated because a relative handful of key people at banks, insurance companies, brokerage firms, corporations and investment advisory firms have had an overwhelming urge to avoid exposure to failing banks and to the debt of companies that could be seized by the government. They are the ones that can move tens of billions with one phone call; the ones who can pull their money from a money market fund before it realizes it needs to suspend redemptions; the ones who gobbled up all the short-term Treasury paper. The evidence of their refusal to buy anything that might be tainted could be seen in soaring swap spreads, incredible volatility (due to a lack of liquidity), and the much-feared, near-cessation of interbank lending activity.

The Lehman CDS auction last week was a defining event for this market. People had lots of time to prepare for it, and there was lots of time for many to expect the worst, which could have been devastating. But with knowledge and preparation, the market avoided a catastrophe. We didn’t need a government bailout or a government takeover or an injection of funds to make that auction and settlement work. The market figured things out all by itself. That is the kind of thing that can restore confidence much faster than any announcement by Hank Paulson.

Today’s news of more G7 bailouts and massive central bank intervention, followed by an explosive equity rally, was a source of great comfort to all of us. But tomorrow I will look for confirmation that I am right. When US banks reopen I expect to see a significant decline in swap spreads, particularly those of short maturities, as well as a meaningful decline in 3-month Libor. If that happens, it will tell me that confidence is making a comeback, and that it’s genuine confidence, the kind that can only come from the market healing itself.

Stay tuned.


Tory Conservative said...


What about the possibility of the government "guaranteeing inter-bank lending?"

This sounds like a bad idea to me.

If one bank is unwilling to lend to another bank, presumably because the lending bank is afriad the borrowing bank will not be able to pay the money back, why should the government step in and, essentially, manipulate the market place with a guarantee?

I see that the Europeans have done this already and some expect the US Treasury to follow along.

What do you think?

I also heard a discussion on CNBC this evening where someone raised the concern about banks making "committments" to loan money back in 2006-2007, when the credit markets were healthier. Now those committments might come due under higher LIBOR spreads.


Scott Grannis said...

Government will only make another mess of things if they start telling the banks how and where to lend. We can only hope that the fundamentals will be improving on their own before the bureaucrats start to peer over the bankers' shoulders.

Pat said...

Thanks again, Scott. I nominate you as "Contrarian of the week" !Pat O'Lear