"Too Many Bullish Arguments Suffer from a Lack of Imagination"

From Tony Jackson's column in yesterday's Financial Times, "Too many bullish arguments suffer from lack of imagination":

There seems to be growing support for the notion that equities have reached fair value. This raises two questions: how far it is true, and how far it is useful.

As to the latter, I described a month ago how the UK consultant Andrew Smithers, drawing on work by the US academic Robert Shiller, concluded the US market was fairly valued with the S & P 500 at 880 - roughly its level today. But as Mr Smithers also found, previous serious market collapses did not end until they were, on average, at only half fair value.

This is unsurprising. If markets never undershot, they would never overshoot either.

Later in his column, Jackson questions the conclusion of Morgan Stanley economist Joachim Fels's recent essay, "Neither Japan nor The Great Depression" (which was the subject of an eponymous post here last week):

Morgan Stanley has just produced a piece declaring that the present downturn is "neither the Great Depression or Japan". The argument boils down to saying that all previous policy mistakes have been avoided this time.

But that, of course, carries a hidden premise: that all possible mistakes were contained in those two episodes. That is, none of today's policy actions will turn out later to have been blunders.

Any takers on that one?

"Neither the Great Depression nor Japan"

Morgan Stanley economist Joachim Fels explains why he believes the global economy is not facing a multi-year deflationary contraction along the lines of the Great Depression or Japan's 'lost decade' in the 1990s in this essay: "Neither the Great Depression nor Japan". Below are few excerpts.

On the policy mistakes that lead to the Great Depression:

- First, the Fed (and other central banks) stood by watching as one bank after another collapsed, and allowed a major contraction of the money supply.

- Second, fiscal policy was passive as governments tried to adhere to the balanced budget doctrine. Falling tax receipts thus led to cuts in government spending, aggravating the downturn in private sector demand. This only ended when Franklin Roosevelt took office as US President in 1933 and created the New Deal.

- Third, starting with the US Smoot-Hawley Tariff Act in 1930, a trade war began between the US and Europe, with governments raising import tariffs and thus choking off world trade.

On why the current situation is different:

Today, policymakers are acting very differently, thanks to the lessons drawn from the Great Depression. Following the collapse of Lehman Brothers, the regulators have made it clear that no systematically important banks will be allowed to fail. Central banks have resorted to major monetary easing, consisting of a combination of much lower official rates and massive quantitative easing [...]. Governments around the world are busy devising and enacting large fiscal stimulus packages. And, it appears unlikely that the world will see another trade war.

On the policy mistakes made in Japan:

- After the equity and real estate bubble burst in 1989-90 and the economy entered recession, for many years banks were allowed to carry bad loans on their books without having to write them down.

- The government only started to inject capital into banks in 1997, seven years into the lost decade.

- Fiscal policy was stimulative, but the direct impact on effective demand was relatively small (less than 1% of GDP in most years), according to our Japan team.

- The Bank of Japan only resorted to quantitative easing (QE) in 2001, more than 10 years after the crisis started.

Why the current situation is different:

By contrast, US and European banks over the past year have been busy writing down bad assets, governments have started to recapitalise banks, major fiscal stimulus is on its way and central banks are not only cutting interest rates but have started QE. The monetary base (consisting of cash in circulation and banks’ reserves at the central bank) is currently growing at rates of 30-40% in the US, the euro area and the UK, and thus faster than in Japan in summer 2001 when the Bank of Japan started QE. And importantly, as David Greenlaw explains in the note that follows¹, M1 growth (cash and sight deposits held by the public) has been surging in the US recently. We take this as an early sign that the monetary policy transmission process is starting to work again.

Fels's bottom line:

Again, it is important to emphasise that the G3 are in a severe recession that will last at least until mid-2009, possibly longer, and headline inflation will likely become negative at some stage next year in the US and Japan and drop below target in the euro area. However, the early and massive policy reaction will, in our view, prevent a replay of Japan in the 1990s or, worse, another Great Depression.

¹The link above takes you to both Fels's essay and Greenlaw's.

The image above, of a comic book cover featuring Japanese Manga character Kosaku Shima, was borrowed from John Richardson's Asian Chemical Connections blog.

Goldman Sachs and Morgan Stanley Approved to Create Commercial Banks

According to the AP ("Last major investment banks change status"), today the Federal Reserve approved requests by Goldman Sachs and Morgan Stanley to change their statuses to bank holding companies and create their own commercial banks. This makes sense, since the large combined commercial bank/investment bank conglomerates (e.g., JP Morgan Chase) have proved to be more stable than the stand-alone investment banks (e.g., Bear Stearns, Lehman Brothers) during the current credit crisis. Something to keep in mind next time you hear a pundit blame the current financial crisis on the 1999 Gramm-Leach-Bliley Act, which repealed the provisions of the depression-era Glass-Steagall Act that separated commercial banks from investment banks.