Return of the Jedi

So, that was the US week that was. The August data flow was probably a little better than I reckoned on but was certainly bad (I tend to move more quickly than an economy does).

Indeed, data was bad enough, especially Friday’s employment report, that the tenure of US debate has clearly shifted from worry about poor growth to what can done to avert recession.

There are two key events ahead in this narrative. The first is Obama’s Friday “Jobs speech” in which he is expected to announce limited measures, such as a payroll tax holiday. Although there have been fringe rumblings of a more innovative and grand plan to “jumbo refinance” American housing.

The second event is the FOMC meeting in two a bit weeks and the prospect of further Fed action, currently thought to most likely revolve around “Operation Twist”. The rebalancing of the Fed porfolio from short term to longer term bonds. Presumably thereby also firing up a refinancing boom (most US mortgages are priced off longer term Treasuries).

Neither of these options will solve the underlying issue of too-much-debt (they just make it cheaper) but both potentially help kick the can down the road and perhaps stave off recession if markets react positively, beat down the dollar and fire a new emergingn markets risk rally.

For the FOMC, I reckon that anything short of a full blown round of new asset purchases will have only a passing effect on markets.

A big Obama plan could have a more positive effect so long as, whatever it is, it also weakens the dollar. Otherwise it too is doomed.

How do I reach these rather bold conclusions?

Sell on News had  a very important post on the weekend in which he quoted the research of Gauti B. Eggertsson and Benjamin Pugsley:

The mistake of 1937 was in essence a poor communication policy. At the time, President Franklin Delano Roosevelt (FDR), his administration, and the Federal Reserve all offered confusing signals about the objectives of government policy, especially as it related to their goals for inflation. In the first year of his presidency, FDR had vowed to fight the drop in prices and to reflate them back to their pre-depression levels (the reference point was often understood to be the price level in 1926). By every indication, the public believed this commitment. But by 1937, the administration began expressing its alarm over excessive inflation despite the fact that prices had not yet reached their 1926 target. Vague and confusing signals about future policy created pessimistic expectations of future growth and price inflation that fed into both an expected and an actual deflation. We leave it open to question whether this communication was due to a deliberate change in policy or due to confusing signals (see the discussion in Section VII, where we propose two alternative interpretations), but we argue that regardless of the reason, the ultimate effect was a shift in beliefs about future policy. Nominal rigidities helped propagate the shift in beliefs into an output contraction and a collapse in prices.

We show that this propagation mechanism is particularly damaging at zero interest rates by constructing a stylized dynamic stochastic general equilibrium (DSGE) model in which the zero bound on the short-term interest rate is binding due to temporary real shocks that make the natural rate of interest temporarily negative. We simulate this model and show that at zero interest rates, both inflation and output are extremely sensitive to signals about future policy. By “extremely,” we mean that if the public’s beliefs about the probability of a future regime change by only a few percentage points, there are very large effects on inflation and output. This effect is independent of any change in the current short-term interest rate, which we assume remains at zero.

In short, when monetary policy finds itself at the zero bound, it has lost its price signaling efficacy. What is left at that point is only the expectations of price signals. Thus the public discussions had by economic leaders around what those signals should be is the new signal.

To my mind this socialisation of price is compounded further by the compromising of the government risk-free rate with the S&P US downgrade. That’s another price signal compromised (if not yet lost).

FT Alphaville discussed this last week as the emergence of “Jedi Economics”.

So, what importance does this have for us in assessing the stimulus options to come and their potential effects on markets? In a word: everything. A world in which the foundation numbers for modeling risk and return have ceased to exert their traditional force is a world in which investment decisions are based far more upon social judgement. That means the communications of economic leaders are everything.

I can see several important implications flowing from this.

First, the FOMC’s current very public conflict and debate is potentially very damaging to growth.

Second, the economic consequences of the toxic debt-ceiling debate are potentially far more damaging and long lasting than I’d previously thought.

Third, in judging the effect of forthcoming stimulus measures on markets, only a much bigger and more united bazooka is going to have any lasting impact.

Either it’s a full blown QE3 or something of similar magnitude from Obama, or it’s bust as far as I’m concerned.

eggertsson_pugsley_2006 (2)

Houses and Holes
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  1. Will the bazooka work, either? In the 70’s & ’80’s, and even as late as the 90’s, it may have done. But now? The West has a cohort of young who can’t afford to borrow and spend, and an aged mass who will hang on like grim death, now, to what they have, as this is the 3rd ‘wipeout’ for some/many of them. And the East? Do they need inflation foisting on their relatively lowly paid citizens at this juncture? I doubt they, and the Swiss and the Japanese, would welcome the bazooka!

  2. That’s not a Jedi, thats Gittins! and he’s pulling a mind trick on us……..

    “There is no downturn”

    “The boom will go on forever”

  3. The force is weak within Obi-Wan Obama so the big announcement this week might be that the Empire really has won 🙂

    I read the FT ALphaville piece last week, and there is a serious message IMO, as the market works on perception and Dath Bernanke’s message is 99.9% cryptic so you can read in many things.

    The bottom line is that nothing Obama does or Ben takes two days wordsmithing will be any short term fix.

    Also, according to ZH the new debt ceiling is reached already….not sure if that is true, but it was reported last week.

      • haha! Nice call Mav, I will pay that!

        But “Toxic debt” means nothing…its like “Structurally lower interest rates”…an emotive term used to gloss over a complex issue.

        • I’m certain the toxic reference was associated with the debt-ceiling debate, in that it was pointless and harmful

  4. The ‘Job Speech’ will be a non-event.

    Given the political mood in the US right now, the Republican party will not let ANYTHING pass unless it’s more tax cuts. US businesses already have plenty of cash, but they’re holding back due to lack of consumer growth. Giving them more money won’t change the situation.

    The unemployed must to be hired for the turn-around to occur. A ‘direct employment’ policy by the government can do this, however the chance of it getting through US Congress is ZERO. High unemployment will increase the chance of making Obama a one term president, which suits the Republicans just fine. The aim and interests of the political elite and the general population are no longer aligned.

    • The US primarily has a jobs problem. Debts, deficits and business confidence all come a distant second. Tell that to the Republicans and the Tea Party nutters.

      • I think the payroll tax holiday is a great idea and would be supported by the tea bag nutters.

        I think the US Financai Bazooka for housing is a terrible idea and would be opposed by the nutters.

        The only nutters left are those that cannot see the failure and limits of Keynesianism.

  5. Because no one has been addressing the root causes of low employment & wages in the US, it looks like its’ bust whatever way Obama & Bernanke choose to play it – the only question is if they want to take the fast road or the slow road to perdition. Even if Obama wanted a full-on WPA-type effort, he’d never get it thru Congress.

    From our (Australia’s) perspective, it would seem that no QE3, or a very limited QE3, is preferable, since a big QE3 would drive inflation in China, forcing a tightening there that we would feel painfully here.

  6. QE2 was designed to prop up the sharemarket. According to ZH

    “Since 81% of all stocks are owned by the top 10%, a stock market crash has little effect on the bottom 90% of Americans.” And
    “A severe decline in the “wealth effect” would probably crimp the top 10% tranche’s carefree spending, which accounts for some 40% of the nation’s consumer spending. If the market crashes, high-end retailers and restaurants would likely see sales fall significantly. While there would be consequences, we should be careful not to overstate the stock market’s role in the nation’s Main Street economy.”
    Hence QE maintains the wealth of the wealthy but does very little for most of US residents.

    Worse still is the impact on US households as a result of printing money.
    This contains a “Handy and thought-provoking chart from JPMorgan making the case that quantitative easing has had roughly the same effect on income as raising effective taxes by one-third for the average upper-middle-class family with $300k in savings.”

    And what about the elderly?
    And the rich
    The rich are saved and the rest have to fend for themselves. The Fed, Congress and the Senate are owned and controlled by big business and the wealthy. Makes you wonder about the great American dream.

    QE3 I suspect will do very little for unemployment and main street America.

    • Michael,

      Unless things change dramatically, it is the road down which we are all headed.

      Egalitarianism is so last-century.

      • Julius,

        I concur but will the downtrodden eventually make a stand in the US!

        Without solving the unemployment / under employment problem the US is going nowhere economically for a decade at least and QE3 doesn’t help in the US or here in Australia (see HnH comments).