by John Quiggin on December 17, 2008

That’s the new target interest rate announced by the US Federal Reserve today (with a margin of up to 25 basis points). It’s also, following the $50 billion Madoff fraud and the increasingly widespread suspicion that the entire bailout scheme has been operated to promote the interests of Goldman Sachs at the expense of its competitors and the general public, an upper bound for the credibility of the global financial system. And it’s a pretty good estimate of the probability that we’re going to avoid a recession worse than any since the Great Depression.

Without a household name like Citigroup or GS going bust, it’s hard to convey the seriousness of the latest news in an environment where we are already inured to financial cataclysms. But it seems pretty clear that the last couple of days spell the end for both hedge funds (many of which have lost a fortune with Madoff and all of which are subject to invidious comparisons with his decades-long Ponzi scheme) and money market funds, which can’t possibly cover their costs given a funds rate of 0.25 per cent.



dsquared 12.17.08 at 7:54 am

Does this mean that, per Bell & Quiggin (2006), because there is no longer any scope to respond to the crash by changing settings of monetary policy instruments, you’d be in favour of a massive financial deregulation? ;-)

(I have a horrible feeling that this facetious comment is going to end up taking the place of a proper post on how the development of the credit deriviatives and synthetic structured finance market between 2002 and 2007 constituted a great big quantitative easing, which allowed the Fed to avoid getting into a ZIRP situation in the aftermath of the dot com crash).


Dave 12.17.08 at 8:45 am

Judging by what the shops on the UK high street are offering now, reportedly an average of 37% discounts, a week before Xmas in the traditional period of pay-anything desperation, by mid-January they will be lassoing customers off the street and paying them to take away the merchandise. Well, that would be the fun interpretation. I guess the less-fun one is where we all get used to not buying anything, and the deflationary spiral locks in.

The only good news in all this is that a slump in economic activity will delay the arrival of peak oil, and if publicly-administered relief is applied intelligently [a big if], then we might be in a better position to cope when it does turn up. Ditto CO2 levels…


Ginger Yellow 12.17.08 at 2:52 pm

“The only good news in all this is that a slump in economic activity will delay the arrival of peak oil”

Conversely, though, cheaper oil means less financial incentive to develop alternative energy sources.


Paul 12.17.08 at 2:59 pm

Did Charles Ponzi realize what he had created in the 1920s with his get rich quick scheme. It still works-modern people are not so smart as we think !!


HH 12.17.08 at 3:20 pm

Bernanke’s problem is that he can’t print trust and honesty. The machinery that produces these crucial commodities operates very slowly. It will take years to drive the liars, thieves, and assorted knaves out of the positions of power and influence they have assumed during the last 20 decadent years in America. Until then, most of the economic policy measures will be well-intentioned theatrics.

It is not in God but in Trust that we must trust if we are to prosper as a nation, and it will take a long time to restore trust among a corrupted people.


Zamfir 12.17.08 at 3:48 pm

Paul, Ponzi schemes are as old as finance. In the days of the South Sea bubble, there was a famous self-described company “for carrying out an undertaking of great advantage, but nobody to know what it is” . If that doesn’t sound like a hedge fund dealing in CDOs…


ejh 12.17.08 at 4:06 pm

Conversely, though, cheaper oil means less financial incentive to develop alternative energy sources.

Not significantly, though, not unless everybody assumes that it will be cheaper indefinitely.


Watson Aname 12.17.08 at 4:13 pm

not unless everybody assumes that it will be cheaper indefinitely.

That seems to be a favorite approach.


Nick L 12.17.08 at 4:39 pm

So I guess this is the end of the new Gilded Age. Funny how commentators are rather less sanguine this time around than they were about the Asian financial crisis, which plunged millions of people in developing countries back into the poverty that they had so painstakingly lifted themselves out of.


Barry 12.17.08 at 5:05 pm

Nick, it’s phenomenally easy to be sanguine about the misery of others. Even in the NYT, my impression is that the problems with Wall St people being pushed down into the sub-$1million/year income bracket is the sort of pity story that they like.


badger 12.17.08 at 5:19 pm

I guess the good news is we can expect a more serious kind of economics blogging once the university pension funds start to go toes-up


MH 12.17.08 at 5:57 pm

Maybe I’m part of the problem, but count me in with the people suspicious that the bailout isn’t in the interest of the general public. Why is the collapse of hedge funds something that I should be concerned about? Also, does anybody know if you use a rasp or a stone to sharpen a pitchfork?


SamChevre 12.17.08 at 6:05 pm

Neither; you use a file.

Basic rule:
Rasps are for soft things (wood, partly dry plaster)
Files are for metal that isn’t especially hard, like most tools.
Stones are for hardened steel, like knives.


MH 12.17.08 at 6:12 pm

SamChevre, thanks. I keep getting “file” and “rasp” confused as I don’t have much use for either.


engels 12.17.08 at 6:15 pm

Goldman Sachs paid Paulson $46 million dollars in the five years leading up to 2006. If his bailout which he engineered wasn’t designed to line their pockets at the American taxpayer’s expense then I reckon they should be asking for some of it back.


Jacob Christensen 12.17.08 at 10:12 pm

We are all Japanese now, it seems. One question – which I am sure economists have answered somewhere – is what Bush43’s deficit policy means for the possibilities of fiscal policies.


sg 12.18.08 at 9:06 am

In response to Dave, and a question I’ve been wondering about for a while now… I lived for 2 years in a country with low inflation/deflation (Japan) where the quality of life was really good. Then I moved to a high inflation country (the UK) in the throes of an asset bubble, where everything is overpriced and rip-offs are a way of life. Everything is so clearly overvalued that a good year or two of discounting would only serve to set prices at sensible levels again.

Given this experience, I wonder if anyone can tell me why deflation is so scary?


Dave 12.18.08 at 12:29 pm

@17: Read the Grapes of Wrath…


MH 12.18.08 at 2:10 pm

“Read the Grapes of Wrath…”
I prefer “Of Mice and Men” because there were a couple of Bugs Bunny shorts that I just didn’t get until after I read “Of Mice and Men.”


sg 12.18.08 at 6:09 pm

but Dave, the Grapes of Wrath isn’t about deflation, it’s about exceptional deflation in a time of economic collapse, right? So presenting that scenario as the reason deflation is bad is like presenting Zimbabwe as the reason that inflation is bad.

But in more normal circumstances, why is deflation of, say -2% worse than inflation of 2%? Particularly when you have already massively inflated prices? My experience of a deflated economy is that no-one was starving and everything was cheap. Here in London everything is overpriced, sometimes by a factor of 5 or 8 compared to Japan, but the wages of most people are nowhere near that much higher than in Japan. So it seems like a lost decade in London might help the bulk of the British population live a better lifestyle. How am I wrong?


Dave 12.19.08 at 11:21 am

Inflation is ‘copable-with’ – everyone just asks for more money. It doesn’t in itself produce anything dangerous at moderate levels, because it can be associated with the ‘inevitable’ consequences of rising economic activity: there’s more, everyone wants more, more comes… Deflation implies declining economic activity, not least through the obvious mechanism of people not wanting to buy now something that will be cheaper in a year – during which time, less work is on offer, so people get poorer, and their assets shrink in value, and they’re even less likely to buy that thing when the year rolls around, so even less work is on offer… It’s a fundamentally more alarming economic scenario, which Japan copes with partly by having a far more robust sense of social order. Western societies teeter on the brink of dissolution already, surfing on a wave of tat from China. Maybe we can get to a better lifestyle, if by that you mean a more sustainable one, but people are going to be going through a horribly frightening time to do so, during which their bitterness might not be easily contained in conventional political forms.

Or maybe not, maybe it’ll all be fine. Who knows. Anyway, you should still read GoW.


MH 12.19.08 at 4:31 pm

Dave, I know that’s the theory. However, my wages haven’t been keeping up with inflation lately (though maybe if I worked out the numbers on health insurance costs…). My 401k accounts haven’t kept-up with inflation, or even held constant in nominal terms. If your savings accounts are paying at significantly greater than the rate of inflation, it probably means that your bank is about to go under. I’m not complaining (that much) as I’ve generally liked my work and we’ve never come close to being short of anything we needed.

However, bailing out people who spent much more than I did and the companies that enabled this is a very hard pill to swallow, especially when the deck seems stacked against everything I’ve done to try to save. Deflation has serious problems, but it will increase the value of what cash I kept out of the market. At the very least, if we have to bailout everybody and their dog, I’d like to see it accompanied by bitterness/arrests/incumbents unelected/bonus clawbacks/etc. The harder the bailout is to get, the less likely somebody will be to think of a bailout in the future.


sg 12.19.08 at 7:59 pm

so Dave, moderate deflation is bad because it is a symptom of economic collapse? Doesn’t seem like deflation itself is the problem. If the problem is that it discourages people from buying things now then what you mean is that a society where people don’t consume is bad. And I would argue that under mild deflation people don’t make conscious decisions not to buy now. They don’t notice the slow decline.

Also why do people make a decision to buy now under inflation? Wouldn’t they simply judge the price to be too much and refuse to buy at all? Currently so much of what I pay for in London is so overpriced that I simply don’t want to buy it at all, because it’s not worth it. It seems like inflation as a sign of economic growth is tied in at some point with asset bubbles, which aren’t real growth, just fantasy money. But fantasy money which makes the wages of anyone whose job is not tied to the asset bubble worth less and less. Whereas mild deflation makes those wages worth more and more – as I think they are in Japan.

(I have read GoW btw).


Dave 12.20.08 at 3:57 pm

“Currently so much of what I pay for in London is so overpriced that I simply don’t want to buy it at all, because it’s not worth it.”

Eh, you pay for it but you don’t want to buy it? Do you buy a lot of stuff you don’t want? What’s your point?

The larger issue is that there are not many people any more whose jobs are not in some way tied to the “asset bubble”. Given how much personal credit is keeping the economy afloat, given that the public sector is paid from tax-receipts which are in decline, given that we are all now thoroughly over-informed about risks in the economy, and too much information is a dangerous thing… It would be nice to think that by some miracle under the current circumstances deflation could create a rebalancing in the economy between the earners and the owners, but I cannot adjust my perception of reality enough to think that it’s a likely outcome.


sg 12.20.08 at 4:35 pm

sorry dave did I miss a single word? So much of what I am asked to pay for in London is so overpriced that etc. No need to be so snarky.

I can’t help feeling that the reason so much personal credit is keeping the economy going and we are all so soaked in risk is that our economic geniusses were busily trying to maintain an inflationary economy. But why? Because “deflation is bad”? Here I am, being asked to pay 8 times what I should pay for a rice cooker, being told that deflation is a bad thing in an economy which is about to collapse because of the unreasonable attempts of our so-called leaders to keep it afloat through inflationary policy. Low interest rates, inflating house prices, continuous consumption on asset bubble finance… all these things kept inflation high, drove up the price of my phone bills, and simultaneously wrecked the economy, but I am meant to believe that deflation is bad?

There’s something missing in this story.


DC 12.21.08 at 10:34 pm

In a deflating economy businesses are forced to sell goods at lower prices, but many of their costs are “sticky downward”, i.e. they are set in nominal terms (contractually or otherwise). The most obvious examples of costs that are sticky downward are debt and wages. Thus deflation drives businesses into bankruptcy and workers out of jobs.

On top of this there is the problem that whereas expectations of rising prices encourage consumers to buy now rather than later (hence frantic cues outside shops with emptying shelves in a hyperinflation), deflation has the opposite effect, causing people to hold on to their cash, expecting a better deal manjana.

I think sg is perhaps confusing the question of inflation/deflation – i.e. changes in prices – with the level of prices relative to earnings at any one time. London could be made more affordable by prices coming down – except that this has the knock-on effects described above. It could alternatively happen if prices rose slower than incomes – nominal prices becoming inflated at a suitably slow rate such that real incomes (affordability) increase.

Of course it may be that a country turns out to have been living way beyond its means (however broadly one construes the means of the country) and real incomes cannot therefore be increased or maintained. In this case it seems better that the requisite decline in real income happens through inflation (and a falling exchange rate) rather than a massive deflation-induced depression.


sg 12.22.08 at 10:42 am

Well DC, isn’t the problem of people consuming less or waiting till later also going to occur in an inflating economy? Do we have any evidence that people notice price rises or declines and incorporate them into spending decisions when the change is slow or small? What about foodstuffs? I think it is much more likely, for example, that people will use their heating profligately in a deflating than an inflating economy – they can’t delay its use and they know it will be getting cheaper over the life of their bill.

For example, Japan has had 10 years of deflation/stagnation but the Japanese are renowned (somewhat unfairly) as consumer-obssessed. How come they love shopping if they’re always putting it off? I would have thought decreasing prices would lead to an overall increase in consumption when people think that things are getting cheaper…

… also, my rice cooker example has me buying a rice cooker for 8 times more than it is worth. Surely the company can afford to cut the cost of that rice cooker without laying off any staff. The prices they are charging are extortionate, and it is that attitude which has caused the inflation in the first place.


Dave 12.22.08 at 11:01 am

Define ‘worth’. I really think you’re not seeing the big picture here. When we complain about stuff being expensive, all we’re really doing is observing that our personal income is a little lower than we’d like. When we say that everything ought to get cheaper, by calling for deflation, we’re demanding a real macroeconomic change: one that, for the reasons repeatedly stated above, will cost a lot of people their jobs, making their personal income a lot lower than they’d like. Bear in mind also that Japan’s deflation was relatively localised, and that one of the things that kept their consumer economy going was the ability to buy cheaper stuff imported from China and Korea. These days we’re all buying that cheaper stuff already, and China is at as much risk from the global situation [if not from actual deflation] as anyone else.

As I’ve already said, it would be nice if the world could bring prosperity a little closer to the average worker, but deflation is not the way to do it.


sg 12.22.08 at 11:51 am

well in this case “worth” is what I paid in Japan, where I was earning more than 1/8th of what I am earning in London, and where demand for rice cookers is pretty high.

I don’t really believe that anyone who looks at inflation in house prices in the UK can claim that it is a good and necessary thing, or that it is driven by real inflationary effects like increases in the wages of people who build houses. It is speculation, and as consequence a huge portion of peoples’ income is being wasted for no good reason, and a small number of people are getting rich. If house prices in the UK were stagnant I think the effect on jobs would be a lot lower than you are suggesting, since the price spirals we saw have nothing to do with economic activity that makes jobs. And I think a lot of inflation in the west is of this sort, to do with easy money fuelling speculation and a culture of rip-offs, rather than real macroeconomic phenomena (like supply constraints) pushing up costs. My rice cooker is not 8 times more in London because the cost of making it was 8 times higher, so why should dropping its price to 6 times more than reasonable cause a whole bunch of people to become redundant?

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