Losses = Lessons Learned?

In Oct. I was concerned that a rate cut could lead to an erosion in Fed credibility. The way I saw it the Fed had to options: hold firm and signal more easing or cut and signal that the easing cycle was over. I prefered the former, the Fed chose the later.

Now, it seems that their decision may be coming back to haunt them. As many have pointed out the situation has detoriated and there is strong reason to ease again in December. I tend to support antoher quarter point cut at this point.

However, what does it say about Fed credibility and foresight that just weeks ago they signaled that the cycle was ending and now it may be begining anew?

On the positive side, though, massive losses by the banks and brokers have loosened some of the concern about moral hazard. With record right downs it is hard to argue that the financial markets have not been forced to account for the excess of the past five years. This is good news for those hoping for more cuts.

Bear Hawk(ish)

I find myself in a unique position among econo-commentators. On the one hand I am bearish about the medium term prospects for the US domestic economy. On the other I am not yet convinced that this demands large cuts in the funds rate.

First, the bear case. It is difficult to imagine a scenario under which domestic consumption does not experience a significant slowdown over the next 18 months. To wax nerdy for a moment the structured finance revolution that gave birth to the housing boom was akin to a massive technological advance for the US, or so we thought.

It seemed as if considerable amounts of risk could be redistributed and managed for much lower costs than in the past. Risk drives a wedge between the interest rate that borrowers are willing and able to pay and the rate that lenders are willing to accept. A reduction in risk means that there are a whole host of new transactions that are now possible.

Like the internet bubble, however, the credit bubble was based on over optimistic assumptions about the power of this technology. Incidentally, the credit bubble was also sparked by large increases in computing power, but that is another story.

The upshot is that even if consumers feel no wealth or collateral effects from housing their borrowing capacity will be reduced.

In addition, we have a number of traditional forces at work. Banks are seeing huge losses on their balance sheets which will lead them to reduce lending. Consumers are facing a decline in home equity which will reduce the collateral they have to post against loans. And, finally people will at least feel poorer as a result of declining housing prices. All of these forces work against consumer spending.


So in the face of all of this why am I not advocating massive rate cuts? Part of the problem is Fed credibility. We experienced a good bit of pain in the early 80s and 90s to get the inflation rate down. The willingness of the Fed to risk those episodes did a lot to promote credibility on the inflation front. I would hate to see all go down the drain now.

Relatedly there is the issue of growth in the rest of the world. It is that growth that is creating inflation pressures, and it is also that growth which has the potential to provide some support to the US economy.

Net exports are surging and will probably continue to do so as domestic consumption slows, foreign consumption rises and the dollar shrinks. Whether or not net exports can prevent the US from sliding into recession is an open question. I tend to doubt it, but the jury is not in yet.

What does occur to me, however, is that by charting a relatively steady course the Fed will allow the trade deficit to unwind in an orderly fashion. Cutting rates aggressively generates a lot of uncertainty.

On the one hand basic theory predicts that a lower funds rate would depress the dollar further and push up net exports. On the other hand, easier money could alleviate consumer pressures, increase US domestic profits and lift the dollar on rising equity values.

If we experience the first case we risk seeing the dollar fall off a cliff. If we experience the second case we suspend the dollar ever higher against fundamentals. The steady but seemingly controlled decline we are experiencing now seems to be working and I don't see why we would want to mess with that.

We keep domestic inflation very low, we let rising commodity and import prices play themselves out. We allow the trade deficit to correct itself through lower US consumption, a weaker dollar and growth overseas.

The result will be a painful course correction for the US economy, but a much needed one that will put the global economy on a more sound footing.

Is Wal-Mart Driving the Trade Deficit

KNZN asks why Europe doesn't have a growing trade deficit.

After all, the euro is surging against the Asian currencies and Asian manufacturing is only getting more productive. If exchange rates and productivity are central to explaining the Asian export story then why isn't Europe more in the hole.

A theory, for which I have as of yet developed no empirical support, is that Asian productivity is not at the heart of this story, nor exchange rates.

The key is US productivity - US retail productivity in particular.

See, economists not only fall into the trap of immaculate transfer, the notion trade deficit magically go away when national savings exceeds domestic investment, but also the trap of immaculate delivery.

In other words, we assume that all that needs to happen is for foreign goods to be produced relatively cheaper than domestic goods and then they will magically be consumed. The problem is that the goods have to get from the foreign country to our living rooms. Somewhere in that process comes retailing.

Retailing is possibly important because we have seen massive increases in productivity over the last 15 years in retailing, with Wal-mart leading the way.

Lets assume the following example:

Suppose that originally an America toy costs roughly $5 to make and $5 to distribute and retail for a total of $10.

Now, you could get a Chinese toy stateside for $1. That means it retails for $6. However, its a piece of crap and it costs about 60% of the the American toy. With the two relatively close in price and both somewhat expensive you might as well opt for the American toy.


Enter Wal-Mart. Efficiencies in distribution and inventory management cause retailing margins collapse so that the it costs only a $1.20 to distribute and sell the toy (gross margin on the American toy falling from 50% to 20%) .

The American toy now retails for $6.20, which is a great deal. Yet, the Chinese toy retails for $2.20. It may be crap but at $2.20 why not just get it!


In this case whats happening is not that Chinese imports are getting cheaper themselves but they are getting relatively cheaper because retailing costs are falling. Just like the well known result that rising excise taxes shift consumption towards more expensive items, falling retail costs will shift consumption towards cheaper items.


What does this have to do with Europe? Well Wal-Mart and big box retailers have been considerably less successful there.

Why up is really down

A few people are questioning whether its strange that surging oil price could led to falling domestic inflation?

It is a little strange at first but the answer is simple.

From a consumers point of view gasoline prices were pretty flat. So the gasoline price change is 0%.

We get gasoline by refining foreign oil here in the United States. So

Foreign Oil + Domestic Refining = Gasoline

However oil prices went up 10%. And gasoline prices stayed the same, So


10% + X = 0% =>

X = -10%

Or domestic refining prices fell by the equvialent of a 10% increase in the price of oil.


That has to be true or else the increasing price of oil would have caused increasing gasoline prices. If something is going up and the total is staying fixed then something else must be falling. That something else is domestic refining.

Now what does this mean for GDP?

Not much. The higher oil prices made our domestic refining seem more efficient which would tend to boost GDP. Yet, the higher oil prices also lowered our net exports which decreases GDP. The two effects cancel out.