Less Policy Advocacy and More Policy Forecasting at Credit Writedowns

Blogs in the econoblogosphere are heavy on economic policy advocacy. Ever since the heyday of the US and European housing bubble, the majority of bloggers in the space who are unaffiliated with media sources have been recommending policy makers take specific courses of action to mitigate downside risk. That is the bread and butter of the econoblogosphere. 

However, it is increasingly clear to me that policy makers in the US, the UK and elsewhere are wedded to a previously chosen set of policy remedies. I think much of this is a function of a political need for ‘policy consistency’; government is saying: "we have already scripted out a path and committed to it. We cannot change course, if only for political reasons.” So, in some sense, it makes less sense to focus exclusively on ‘advocacy blogging.’ Personally, I have been increasingly focused on understanding what constraints policy makers have set for themselves to identify a more narrowed set of likely policy paths. The goal is not to advocate one option over another per se, but rather to figure out what is likely to occur and what the consequences will be for the economy, business, households and investors.

For example, when I wrote the post "The recession is over but the depression has just begun" a year ago, this was my goal. At that time, looking at the US, it had become clear to me that the Obama Administration had already done so much regarding bailouts and stimulus and the rhetoric to defend this program that it would be difficult to correct course. The question was: Given the Administration’s prior policy decisions, how would their political options be narrowed in future? And what were the likely effects of the policy options they then chose? I think understanding policy is critical now because the weakness of the developed economies puts a nascent technical recovery at stall speed – meaning that there is less room for error and policy decisions will loom that much larger as a result. Re-read the last section called "So, what does this mean for the American and global economy?" from that post and you will see what I came up with.

Here are the critical elements as I saw them then (and still see them):

1. The private sector (particularly the household sector) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector
2. Consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar.
3. Because of continued economic weakness, deficit spending on a mammoth scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life.
4. Meanwhile, all countries which issue the vast majority of debt in their own currency will print as much money as they can reasonably get away with.

I think this is pretty much what has happened (correct me if I’m wrong). So I ask myself where that leaves us now. And again the answer must be predicated on an understanding that political factors will force government to make decisions purely for the sake of consistency with previous policy decisions. It is a basic human tendency to want to cover-up past mistakes, so where government actors are the same, we should expect future policy to re-enforce previous policy. Where government actors are different, because the global economy is still not strong, we should expect policy to exaggerate differences from previous policy.

This is sort of my framework in thinking about these issues right now. Let me just touch on two countries as examples before I hit the send button.

In the US, the Obama Administration will soldier on at least through 2012.  In all likelihood, Congress will become more Republican. This means that after the mid-term elections, Congress will often want to demonstrate how terrible a job the Obama Administration has done in fixing the economy. It can only do this by focusing on policies which exaggerate differences: stimulus, bailouts, health care (correct me if there are other areas you think I missed).

So this will mean Republicans will show extreme opposition to any stimulus, any bailouts and may look to rescind the healthcare bill already passed by whatever means necessary. Likely, stimulus is out for good now. The Obama Administration clearly understands it made a tactical error in predicting a more robust economic outcome while bailing out the financial sector. This has left it in a bind because they are trying to argue that the stimulus prevented depression when (the U-6 measure of)underemployment is still 17%. I anticipate the Obama people will change tack because the Republicans will beat them over this. It is not clear yet what they will do in order to demonstrate their ‘for and by the people’ stature. However, I have speculated that the Administration will become even more conciliatory toward the financial sector (which feels aggrieved because of populist rhetoric) in order to deflect Republican criticism about being anti-business and to protect their previous policy decisions. This necessarily means being somewhat more aligned with the banks in the foreclosure crisis. The Obama Administration cannot possibly take a hard line via foreclosure moratoria or a bank holiday because the outcome would simultaneously reflect poorly on previous policy decisions and risk the technical recovery. Remember the Obama Administration needs to convince us that more bailouts were necessary in 2009 in order to be successful in a 2012 match-up. The only way it can do so is both through a sustained recovery and keeping the banks from being exposed to another systemic crisis.

The Federal Reserve will also need to protect previous policy choices since the actors are the same. This means more quantitative easing.  I have speculated what form this would take – not because I think QE is a good policy choice but because we need to understand what is likely to occur. Buying mortgage paper has been broached. If you want to do QE, this is a good way to get some extra kick. But it opens the Fed up to charges of politicizing its function and doing fiscal policy. So  assume it will float the idea to let it gain legitimacy and then only if the economy is in really dire straits might it proceed.

In the UK, the Tories need to demonstrate that they are choosing a different path than the previous Labour government. First and foremost, this has meant austerity in order to contrast the coalition government with the ‘reckless’ free spending ways of the Labour government. The problem is that this leaves the UK in a tenuous positionregarding recovery. There is no sense in having austerity if it means a recession or worse. So, we are going to see QE from the BoE as well. Notice that British rates are at their lowest level since the 1960s – and this is not because of confidence in the coalition government as some media outlets would have you believe. It is purely a calculation of the likely path of inflation in an austere budgetary environment. It requires a lower nominal yield to compensate an investor for a desired yield pickup if inflation rates are falling.

In regards to the bailouts by Labour, this will be another point of differentiation.  Notice the bank tax in the UK – by a right of centre government – stands in marked contrast to the lack of one in the U.S. by a left of centre government. This owes wholly to the need for policy contrast versus continuity, nothing more. Here’s the question: if austerity is a bust despite QE and the banks get into a pickle because house prices tumble, what then? I think, the coalition government would be forced to offer up at least one firm as a sacrificial lamb.  I a not talking about a Lehman-style bankruptcy but rather a seizure, liquidation of non-government equity holders and haircut for bondholders. Given that RBS is the weakest player, since Lloyds was much stronger pre-HBOS acquisition, I see the firm as the company to watch in this regard.

That’s my thinking for now. Going forward, I am going to be anticipating policy and make some comments about what that means for the economy. That will mean I won’t always be speaking in ‘my voice.’ Please provide feedback as we go along. I’ll certainly have more in the coming days and weeks.