The Essence of our Predicament

The essence of our economic predicament is that the cost of debt has risen dramatically on instruments the Fed can’t control: longer durations and riskier issuers.

This happened to corporations and consumers simultaneously. Both rises were essentially unexpected, i.e. not priced in. Now we’re getting whipsawed as realization of the new cost of capital is priced in.

Other things equal, disinflation or deflation is the logical result of an uncontrolled, unexpected, sustained, large increase in the cost of capital.

Fed rate cuts can mitigate that, but not as much as desired, because most of the problem is concentrated at the other end of the risk and duration spectrum, e.g. 30 year mortgages or BBB corporate debt.

This essentially all resulted from a loss of faith in the judgment of the rating agencies, and in the solvency of the debt insurers. The Fed rate could go to zero, and banks would still be afraid to lend to a BBB credit, because they can’t be sure it’s really BBB any more, or that they can insure reliably against a default. So restoring faith in the ratings agencies and debt insurers is probably a prerequisite
to flattening both the yield curve and the risk premium.

As long as it stays like that, we appear to be facing an era in which asset prices are falling and cost of servicing debt is rising, so that seems deflationary. The alternative, which I prefer, is to cut Fed
rates so aggressively that things go the other way, i.e. dollar falls, durables prices rise, etc. But keep in mind that fewer people have much equity left to buy things with, no matter where rates go.

That’s how it looks from this armchair.

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2 Responses to “The Essence of our Predicament”

  1. arroyogrande Says:

    I agree…you can lead a horse to credit, but you can’t make him drink. I’d be willing to bet that we are getting close to the "pushing on a string" phase, if we are not already there. Although I can’t really imagine we would go into a deflationary period, that feeling isn’t from an academic sense; it’s just that I’ve never seen a period of sustained deflation, so the notion sounds strange. We will see…if we see deflation, we’ll in theory have a chance to refinance our fixed rate mortgages into an even lower rate, and hang on hoping that wage deflation doesn’t make the monthly payments impossible. If we get wage deflation, all bets are off, as all forms of real estate will crash into an economic crater the likes of which haven’t been seen before…if house prices rose are currently too high vs. incomes, just think what the *nominal* house prices would be with deflated [more buying power] dollars.

  2. arroyogrande Says:

    Chris Dodd, the chairman of the Senate Banking Committee, is now "floating the idea" of creating a new "Home Ownership Preservation Corp." to buy troubled mortgages and place the borrowers in less costly, refinanced loans and that this proposal should get "serious consideration". In inflation adjusted dollars, we are already spending what it cost to bail out the savings and loan industry on just the "stimulus package". Putting the taxpayer at risk for a massive amount of bad loans in order to keep people in houses that they could not realistically afford by creating a "Home Ownership Preservation Corp." is just crazy. – arroyogrande