Whatever It Takes

Richard DeKaser

The government's response to the unfolding crisis, until recently, has mostly been a day late and a dollar short. Only after banks curtailed lending to one another, for example, did the Federal Reserve vigorously invite them to the discount window. And it was only after they failed to partake that the Fed developed an alternative auction program to provde them with funds. Later, when wholesale funding markets became unreceptive to investment bank borrowing, the Fed offered them the same terms as commercial banks, but only after the Bear Stearns collapse. The same critique may be made of the other policymakers, including those at Treasury and the housing agencies.

All of this is completely understandable, to be sure. Precisely navigating problems of such complexity is nearly impossible. Nonetheless, the ad hoc policy response - measure and deliberate though it's been - has still fallen short, which may explain why confidence levels are so very dismal.

This isn't to say that conditions aren't themselves dismal. They surely are. The economy is freefalling at the moment and confidence levels should be low. At the same time, confidence seems to have over-shot to the downside. As previously discussed (What's Bugging America?, June 2008), opinion poll readings of consumer confidence have fallen well short of their usual relationship to fundamentals, such as unemployment, inflation and stock prices.

The same seems true of dim investor confidence, which is unprecedented in many respects. Corporate bonds, for example, now yield 6 percentage points over comparable risk-free Treasuries. Even during the severe recessions of the 1970s and 1980s, this risk metric never exceeded 4 percent.

Similarly, the S&P 500 is now delivering a dividend yield of 3 percent, which is better than the 2.6 percent yield on 10-year Treasuries, unique to the past 40-year record, at least. Implicitly, this means investors either expect interest rates to rise sharply, or, more likely, for dividends to fall sharply going forward.

Why might confidence be so bad? One answer is a condition psychologist's call "learned helplessness" - a clinical response to prolonged exposure to unpredictable negative events. Like a prisoner subjected to harsh interrogation, the loss of control, even if only perceived, frequently results in the surrender of will and depression.

If this diagnosis is accurate (the alternative being that things really will become that bad), then the prescription is to swap the incremental, piecemeal approach of the past year for  the financial equivalent of the Powell Doctrine: that every resource and tool should be used to achieve decisive force against the enemy.

More to the point, this shift seems to already be underway. The Fed recently announced a series of truly extraordinary policy actions that transcend the previous approach, including the forthcoming purchase of up to one-half trillion dollars of mortgage-backed securities. Additionally, and importantly, these monetary actions are now slated to coincide with a fiscal stimulus package that far exceeds any of its predecessors.

President-elect Obama's pledge to do "whatever it takes" will be tested in the months ahead, but at least that disposition is now broadly shared by those with hands on the levers of economic policy. (12/15/08)

Richard DeKaser is the Chief Economist for National City.
Copyright 2008. All Rights Reserved.

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