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August
29, 2002, 9:00 a.m. |
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he outlook for the global economy appears to be deteriorating amid falling
optimism. The U.S. index of leading indicators fell 0.4% the third decline
in the last four-months. No single development has accounted for the negative
mood. Yet nearly everything that has occurred since the beginning of summer
is being interpreted in the worst possible light. Some people fear deflation,
others a double-dip recession. But a combination of the two are more likely
than either one by itself.
The recent stock-market declines have substantially reduced the net worth and credit worthiness of borrowers. The market decline also reduced the net worth of lending institutions. That means that even with the same ratios of capital, these institutions will be curtailing the amount of credit that they extend. Add to that concerns of regulators and "a higher risk premium," and credit will unambiguously contract.
In turn, reduced credit has a negative impact on the economy resulting in lower GDP. The economic slowdown will produce a lower profit outlook, which in turn will impact the market in a negative way, and a second round of credit squeeze will begin. The economy will get caught in a down draft, or vicious cycle, which will gives us a very simple explanation for the double dip.
And how will deflation set in? Consider what happens to financial institutions as they curtail their lending activities. In the case of a bank, a reduction in lending requires either a decline in the deposits or an increase in the reserves held by the financial institution. Either one of these will have an impact on the total amount of credit in the economy as well as the quantity of money created by the financial institutions.
The lower credit results in a higher interest rate charged on loans. Absent any additional injections of cash reserves into the system by the Fed (i.e., the Fed holds the base constant), the reduction in deposits and/or the increase in reserves will reduce the quantity of money circulating through the economy. If the slowing of the money growth is greater than the economic slow down it would produce "even less money chasing the fewer goods that the double-dip recession could produce." The market's way of inducing people to hold fewer deposits is to have a decline in the interest rate paid on the deposits held at the bank.
One important point that seldom gets mentioned when people discuss the ccredit crunch is that as long as capital is the binding constraint, there is very little the Fed can do to nudge the banks into lending. Increases in the monetary base become reserves at the banks that will not be "multiplied." Sometimes this condition is referred to as a liquidity trap.
The way out of the problem is not by printing money. The solution is to restore the credit-creation ability of the system. There are several ways this can happen.
The first is that the relevant regulatory agencies should ease the lending standards. This allows institutions to increase the amount of credit in the economy and that in turn supports a higher level of economic activity. Another way is that the institutions re-capitalize themselves. And a third way requires an increase in the net worth of the borrowers.
The simplest and fastest way to increase the net worth of the market participants — or the borrowers — is through a tax-rate cut. A capital-gains tax-rate cut or the elimination of the tax on dividends are measures that could have an immediate positive effect on household net worth.
Just as the conditions that could simultaneously produce a double dip and deflation are apparent, the ways to counter such an awful turn of events are just as obvious.