Color Me Confused: The Fed & The Economy

Color me confused.

This morning's Wall Street Journal noted,

"But the Fed's statement Wednesday dropped any reference to the economy recovering "later this year," hinting at the reasons for its drastic move and a warning sign for anyone piling into stocks."

But, didn't Bernanke just appear on CBS' 60 Minutes last Sunday to spread the word that the US recession would be over later this year?

Am I to believe that, in only two days, the US economic picture has deteriorated so much? Or was Bernanke just lying, to spread confidence? Or, did he simply not really have a well-informed view on the economy?

Here's what else confuses me.

Essentially, beginning in the summer of 2007, with the collapse of two Bear Stearns mortgage-backed instrument mutual funds, there has been a global reduction in leverage. That is, the creation of debt capital by many parties began to be reversed, first by the reduction in the market values of such debt, and, subsequently, the failure of lenders to provide new cash in exchange for maturing debt of various types, especially short term notes financing entities such as mutual funds holding structured finance instruments of dubious value.

As such, we are in the midst of a rare, but clear global contraction of leverage.

Simultaneously, the US began to enter a naturally-occurring recession. Recessions occur periodically as a natural part of economic cycles. They cannot be avoided, but sometimes can be softened.

In this case, however, the combination of the global contraction of credit and the US recession have resulted in GDP and employment declines on an order similar to that of the 1981-82 US recession.

We didn't see an FDR-style New Deal in response to the Carter-induced 1981-82 recession. Spending didn't skyrocket.

In fact, President Reagan quickly moved to cut spending and tax rates. And that worked. Those actions laid the foundation for twenty years of healthy, productive US economic growth, during which the several recessions were relatively mild and short-lived.

What am I missing?

What has changed, besides the tendency of Americans to now believe panicky calls that the economic sky is falling?

Whether you believe Alan Greenspan's recent, continuing self-defense in the Wall Street Journal, that he was right, and Stanford's estimable economist, John Taylor, was and is wrong, or not, it's a fact that too-cheap money in the US, in the wake of the technology equity bubble collapse, led to irresponsible debt financing of risky mortgages.

I wrote recently, here and here, of the phenomenon which we are currently experiencing: the combination of global deleveraging and recession. In the second post, I noted,

"On one hand, there is, based upon the NBER's December statement based upon job losses, a US recession which began in late 2007.

However, within this recession is a secular trend of economic shrinkage that will not be reversed by anything but a return to higher leverage. Thus, no amount of unleveraged economic 'help' will reverse these losses and the accompanying fall in GDP growth.

Seen from this perspective, the only way in which a new, massive Federal stimulus package can provide 'recovery' is to substitute government-issued obligations to return US societal economic leverage back to the dangerous, unsustainable levels at which it was before the current crisis.

How is it that leverage undertaken by the private sector, and judged imprudent, can now be replaced with government-sourced leverage, in the form of either: 1) more printed money, or 2) increased sale of government debt, without creating even more risk by spending the money in less accountable, measurable ways through political channels?

The simple fact is that, for the US economy to lower its capital leverage, and adjust to that lower leverage level, some jobs and business activity will have to simply vanish and not return. Whatever economic level we enjoyed, from which our current recession guideposts are measured, it logically follows that we cannot return there anytime soon unless we collectively decide, as a society, to try to raise financial leverage back to what it was.

If we decide this is unwise, then we have to accept that unemployment will be higher, and business activity levels lower, as the marginal, leveraged activities have been eliminated with the fall in financial leverage.

There is no other way around this fact."

This week's indication by the Fed that it will use newly-printed money to buy Treasuries, and other, less-highly rated assets, in order to effectively provide leverage to the US economy, would seem to be returning us to exactly where we just came in mid-2007.

Why is it so hard for people to simply accept that the economy, and our level of economic activity, will be smaller and lower, until such time that lower-leveraged business activity grows back to GDP and employment levels earlier seen with higher leverage?

Anything done in the meantime to simply "create jobs" or "provide credit" when these are not truly market-driven activities, will be, of necessity, temporary and market-distorting. What deserving business activity is awaiting credit?

Isn't the situation of our commercial banks one of having money for which there are few attractive opportunities to lend?

Isn't this week's Fed statement simply delaying the inevitable? That is, the return of economic activity, leverage, employment, and other related variables back to their deleveraged levels, until such time as genuine private capital investment underpins real economic growth, rather than false, government-stoked temporary inflation, job- and money-creation?

If our government institutions replicated their actions of 1981-82, rather than those of 1932-38, perhaps we would see a faster, healthier and more reliable end to the current recession, rather than the creation of an atmosphere of panic and deep crisis, where none exist.

By claiming that banking, economic activity, and housing are all in a deep crisis, our various governmental entities seem to be prolonging our economic difficulties. Why treat a recession as worse than it is, and ignore conventional, previously successful tools, like tax and spending cuts?

I think what we need is properly-scaled, fairly routine actions like those of 1981-82, which led the US out of that recession, rather than unusual, crisis-oriented actions like those of the 1930s, which we now know prolonged and deepened that depression, without ever actually ending it.