Thursday, December 13, 2007

The Approach of Terra Firma

A man on the 100th floor of a very tall building jumps out of a window. After falling 90 stories he remarks "Say, this isn’t so bad. I feel great. Wind through the hair is kind of exhilarating."

Consumer spending is up, and Pollyannas conclude that the economic outlook is positive. Unfortunately, there's little reason to believe this. Today's new PPI figures show that prices for finished goods rose 3.2%, a substantial increase. Nothing to worry about, right? Nothing to worry about, so long as the Fed remains vigilant in its battle against inflation by raising interest rates.

Oops. And oops.

The difficulty is that the government has put itself into an impossible place. The Treasury has borrowed to finance the deficits, and the Fed has expanded the money supply to help keep interest rates low. Malinvestment, driven by cheap credit, is now being revealed, as the housing bubble pops. In order to try to "soften" the subprime landing, the Fed needs to keep expanding the money supply, thus lowering interest rates. But to fight inflation, the Fed needs to contract the money supply. Yes, oops.

We ought to let the subprime crisis alone, and stop this destructive "fine tuning." Laissez faire is long overdue... it's time for an end to Fed tampering with the money supply, and the Fed itself for that matter.

With this in mind, increased consumer spending isn't so exciting. Looser money supply, increased spending (more consumer borrowing?), continuing falling home prices (less consumer wealth), more bad subprime loans revealed, more government spending... this is a recipe for a bad comeuppance.

Tomorrow's CPI figures will be interesting. The ground approaches.

I couldn’t agree with your analysis more.
Unsurprisingly, the new CPI also indicates general price increases. A big component is rising energy prices; this really is not inflation, but a real effect. But prices in general are increasing.

Meanwhile, central bankers in Europe are nearly in a panic over the subprime debacle and the falling dollar.

It will be interesting to wtach the Fed "fine tune" its way out of this mess.

Thanks for your comment.
As usual, most commentators focus on the symptoms and not the cause. Artificially induced credit finds its way into malinvestment of some kind. Other considerations determine whether it is housing, industrial expansion in capital goods, etc. The debate seems to be around the subprime industry as if that was the problem.

In actuality, market feedback was fast and swift. In 2006 as the delinquency rates was obvious after just a few months of data, analysts were warning that cumulative losses (which takes years to accumulate) were going to be at record levels. The record level of no-doc and low-doc loans wasn’t hidden from the investors nor was the obvious softening in the housing market. The creation of derivatives, like the ABX, helped to short the market and move wealth from those who were ignorant to those who understood the problem.

Now, many want to slow down the correction and liquidation of malinvestment. And inject more credit to support these investments.

The popular press debates the details of subprime loans, the mortgage industry, etc. This reminds me of the inflation debates of the 1970s when the debate was: are wages or prices responsible for the inflation spiral. Of course, they’re both the effect of monetary policy (which is often an aid to bad fiscal policy). Now the debate will be was it borrowers or lenders who are to blame? This is a distraction. The market will "punish" borrowers, lenders, and investors as appropriate. It has already. But the government policy isn't discussed.
Somehow I missed this excellent comment until now (29 Feb. 2008).

Extremely perceptive and on target.
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