Credit Cycle: Breakdown, Adjustment and Rebuilding in the Financial Sector
“Growth takes place whenever a challenge evokes a successful response that, in turn, evokes a further and different challenge…a response that had been both an effective answer to the challenge that had called it forth and at the same time a fruitful mother of a new challenge requiring a different response.”1
Arnold J. Toynbee
Apologists for monetary policy actions often resort to the straw man of posing a false choice between two alternatives for monetary policy—either that policy is completely effective or totally ineffective. This is not the crux of the debate. First, we should recognize that the breakdown in the credit system has diminished the impact of traditional monetary policy, conducted through open market operations aimed at altering the fed funds rate, to restart economic growth.2 Second, recent non-traditional monetary policy appears to be effective in the short run but may be counterproductive in the long run.
Problems about the Federal Reserve’s exit strategy are far more complex for private markets than the casual assurances that are given so freely by many popular commentators. First, the impact on market pricing and liquidity will likely be significant in those markets where the magnitude of Fed actions is very large relative to size of the markets—mortgage-backed securities (MBS) and asset-backed securities (ABS), for example are edging back to the narrow spreads that were associated with the excess credit problem in the first place. Second, it is not clear that inflation expectations are remaining stable as TIPS, long-term Treasury and Fed breakeven inflation rates are already moving up as investors are doubting whether the Fed will really be flexible in the opposite (tightening) direction by raising rates quickly if there is a rapid recovery in financial markets or upward shift in projections for future inflation. Third, contrary to policymaker assertions, many investors already doubt whether federal deficit estimates and expectations are anywhere near realistic. This calls into question both temporary and longer-term fiscal policy. Already, private deficit estimates are rising in anticipation that administration and Congressional sources will raise their mid-session deficit estimates. Finally, political emphasis on jobs and housing suggest that the political risk for investors is that inflation targets will be sacrificed in favor of goals for the real economy. With the passage of time, we believe the exit from easy monetary policy is becoming more expensive and more fraught with risks for investors.
Credit—Not Housing: A Model of the Breakdown in the Credit Cycle
Long before the collapse in the housing market, the global glut in savings was cited as a possible force that would lead to lower real interest rates.3 These low real rates were a concern at the time because of the possibility that they would lead to excessive risk taking and indeed, they appear to have done just that. An excess supply of capital, due to the global savings glut, generated an excess demand for goods financed by credit—housing and autos for example, that in turn led to an excess demand for labor in the construction and auto sector. Therefore we do not view the current economic difficulties as originating in a housing crisis but rather a credit crisis driven first by excess global liquidity.4 In fact, for some time now, many analysts have commented upon the sequence of price bubbles—dot.com and housing being two of the latest examples—that reflect the ongoing excess supply of global liquidity.
Phase I: Breakdown—Collapse in the Credit Market
By early 2005 subprime mortgage delinquency rates had already started to turn upward, and by mid-summer 2005 home price appreciation was peaking on a year-over-year basis (Figure 1).5 Meanwhile, aggregate consumer and residential loan delinquencies were clearly on the upswing by mid-2006 (Figure 2). Consumer credit risk had been under priced; in our view, symptomatic of an excess supply of capital that was funneled into excess housing.
