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Saturday, October 13, 2007

"The Narrative is Still Unfolding"

Robert Shiller says that though some are starting to sound the all clear sign for the economy, it's too early to conclude there won't be tougher times ahead:

Sniffles That Precede a Recession, by Robert Shiller, Economic View, NY Times: A recession has much the same pattern as the flu — starting with vague feelings of malaise and quickly building in misery until a patient’s activities are drastically curtailed. Then, all too gradually, comes an extended period of recovery...

With the unemployment rate up to 4.7 percent in September from 4.4 percent in March, the economy is feeling a chill. Is it descending into recession? Most economists seem to be concluding that the current unpleasantness is a false alarm. They point to some good vital signs: the stock market is up, the dollar is cheap, the rest of the world is strong and the Fed is ready to respond.

But there are worrisome symptoms... The most important is a creeping sense of malaise that could turn into a general loss of confidence. The downturn in the housing market and the repercussions in financial markets are critical factors. ...

Diagnosis of a recession is hard because ... a recession seems to be a result of a confluence of many hard-to-measure factors. A decline in investment spending is typically one of them, and a recession is generally one of those rare events when residential and nonresidential investment both happen to decline together.

In some respects, the current situation looks a lot like the period leading up to the 1990 recession. We were coming out of a housing boom then, and the economy was emerging from an associated lending crisis — the savings-and-loan debacle. Now we are dealing with the subprime mortgage “crisis,” but so far, we have not seen the decline in nonresidential investment that occurred in 1990.

There are also some similarities to the 2001 recession, which likewise followed a huge speculative boom. The bursting of the Internet bubble brought a huge decline in corporate investment, and the 2001 recession helped to cleanse investors of their exaggerated hopes for the stock market, particularly for technology and the dot-coms. A similar cleansing of thinking appears under way regarding the housing market. But residential investment is not as big a component of gross domestic product as nonresidential investment; the decline in the housing market has apparently not yet been enough to push us into recession territory.

Consumer confidence indexes have not yet fallen as they did at the onset of the last two recessions. But confidence is a delicate psychological state, not easily quantified. ... It is clear that salient, emotion-arousing narratives — those that capture the popular imagination and damage public confidence — are central to the etiology of recessions. As these stories gain currency, they impel people to curtail their spending, both in business and their personal lives.

Is this happening now? A disturbing narrative began to unfold in the last couple of months. People began talking of failed institutions — of the possibility that savings socked away in a money market account might actually be invested in subprime loans and so be lost. There has been fear of locked credit markets, of possible bank failures and runs on banks.

Some of these tales have faded — bank runs no longer seem a risk. But confidence in the economy remains fragile. More shocks are likely as an era of huge real estate speculation apparently ends, with the possibility of further surges in foreclosures and failures of financial institutions.

The narrative is still unfolding, and the extent of its virulence is not yet known.

This is related. Treasury officials are asking large banks to create a backup fund to "buy risky mortgage securities and other assets" and unfreeze problem areas in credit markets:

Banks May Pool Billions to Avert Securities Sell-off, by Eric Dash, NY Times: Several of the world’s biggest banks are in talks to put up about $75 billion in backup financing that could be used to buy risky mortgage securities and other assets, a move designed to ease pressure on a crucial part of the credit markets that still looms over the broader economy.

Citigroup, Bank of America and JPMorgan Chase, along with several other financial institutions, have been meeting to come up with a plan to create a fund that could prevent a sharp sell-off in securities owned by bank-affiliated investment vehicles. The meetings, which began three weeks ago, have been orchestrated by senior officials at the Treasury Department...

A broad framework for an agreement could be reached as early as tomorrow, ... but many important details still need to be hammered out ... and it still possible that the parties will not reach agreement.

The proposal recalls the 1998 bailout of the hedge fund Long Term Capital Management, when a group of big banks came together to prevent the fund from collapsing after it made a series of bad bets. But it also shows the heightened concerns of both government and financial players that problems in a crucial part of the credit market have not stabilized ... and threaten to derail the overall economy. ...

The effort to create a backup fund began at the behest of Mr. Paulson. The freeze in markets for commercial paper had shown very limited signs of thawing, but Wall Street firms were having almost no luck finding buyers for mortgage-backed securities and derivatives.

Mr. Paulson called a meeting that included the chief executives of Citigroup, Bank of America and other big banks to see what could be done to relieve the bottleneck. ...

While it may seem as though these private banks could have met by themselves and agreed to create a fund without pressure from Treasury to do so, apparently there are times when the private sector cannot take care of itself and it needs the government to intervene and prod it in the right direction, at least that appears to be the attitude at Treasury (and I wonder if there will be government guarantees of any sort as part of the bargain, a situation that rules out the private sector doing it on its own, but also a situation that more explicitly recognizes the existence of market failure and the need for government intervention to overcome it). It would be refreshing to see this same attitude extended by the administration to other markets that cannot coordinate properly or that suffer from significant market failures of other types, markets that produce outcomes where, say, children are left without health coverage. But don't get your hopes up.

    Posted by on Saturday, October 13, 2007 at 02:34 PM in Economics, Financial System, Housing | Permalink  TrackBack (0)  Comments (15)


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