There is No Tightrope

The analogy of Ben Bernanke walking a tightrope between a recession and inflation has become popular of late. However, I suspect that the Federal Reserve increasingly is coming to believe, as I do, that there is no tightrope.

Inflation is here, yes. Commodity prices in general and agricultural prices are skyrocketing. This is something that we talked about here last year. However, the Japanese Scenario is becoming more salient everyday.

As I say regularly to my colleagues, "This is not just sub-prime, this is not just housing. This will get much worse before it gets better"

I am sorry that I do not have the time to post lots of interesting graphs as evidence. What I am worried about, however, is a recession within a recession and the consquences for solvency in the financial sector.

So far there have been some very high losses associated mostly with subprime mortgages. However, this is potentially the tip of the iceberg. Much larger losses will could come from the set of mortgages known as Alt-A, along with consumer credit, commercial real estate loans and corporate loans.

Now, unlike subprime many of these loans will not experience high default rates in the absence of macro events such as declining home prices or rising unemployment. Therefore, those losses are starting to trickle in now. Alt-A today for example is probably at the same point in the rising default cycle as subprime in late 2006.

We see that home prices are falling but what about unemployment. If we look at the business cycle spikes in unemployment are typically led by a slowdown in residential construction and are accompanied by a drop in business investment spending. In fact by the time unemployment spikes residential construction is typically on its way back up.

This time may be different. Business investment is already slowing and unemployment rising. Yet, there is reason to believe that residential construction could fall throughout the rest of the year.

In a sense this means that we will be in the midst of a recession (high unemployment), at the same time that we are experiencing leading indications of a recession (construction slowdown). This sets up the possibility for a vicious cycle in which unemployment further depresses housing which leads to even greater unemployment, or a recession within a recession.

This scenario must be avoided. The Fed should acknowledge that inflation is a problem but should begin to brace the nation for a policy designed to beat back a Japanese style depression without regard for the immediate implications for inflation.

It Only Seems That Way

"Why would you ever want to take on more debt than your home is worth," ask Mike.


The short answer is that when you think liquidity is going to be a problem it is always better to have money in the bank and higher debt than no money in the bank and lower debt.

A longer answer is that people often think of taking out loans so that you can buy something you want. Ultimately, this is what most people do with borrowed money. However, you can also take out loans just to have more cash in the bank.

This is what I suggested that homeowners do. You never know when you will have an emergency, loose your job, etc. If you have credit available then you can whether those situations. If not, then you may be forced into dire straits such as foreclosure.

Therefore, if you think your credit is about to dry up, its always in your interest to pull out the money now. You can put it into a high yield savings account. If you never use it then you only owe the difference between the interest you are paying and the interest you are getting.

If you do use it then it could save you.

Now, thats the responsible take. Their is a less responsible corollary. That is, if you are planning to spend way beyond your means then you might as well borrow that money at 8% from your home equity line of credit, rather than 23% from your credit card.

In either case, it is better to borrow cheap easy money then be stuck borrowing expensive money or being short of money.

Of course, it would be better still to save responsibly and be lucky enough not to have an emergency. However, many people who have decided to live beyond their means are not going to stop until they are insolvent and almost by definition its difficult to control emergencies.

I don't know if that helps, but its important not to confuse borrowing with spending. Borrowing is a lot of money is imprudent. Spending a lot of money is imprudent.