More on Fisher and the Theory of the Great Depression

In 2006 a Mr. Alex Grey had posted an insightful comment on one of the financial blogs which we have kept in mind. Here it is in its entirety.

There was definitely a hole in Keynes' theory of the Great Depression. This has thankfully been filled by the article "Fisher, Keynes and the Corridor of Stability" by Robert Dimand (American Journal of Economics and Sociology, Vol. 64, No. 1 (January, 2005), pp. 185-199).

This article is I think the missing link that established that the Keynesian Liquidity Trap that characterised the Great Depression was a result of debt deflation as described by Fisher. This establishes that Friedman and Schwartz's view of the great Depression has the causality reversed - the economic contraction led to the contraction in monetary aggregates, notably M3. The Fed or its the equivalent could do little to avert this.

I think averting the process of debt deflation cannot be accomplished through monetary policy (Bernanke following Friedman believes the opposite). This again points to the contrast between Keynes and Friedman.

Evidence in support of the incorrectness of Friedman's view is seen in the experience of Japan in the 1990s where the government succeeded only in increasing M1 while M3 continued to shrink (see paper by Krugman (1997 on this) and asset prices, notably housing, continued to fall. The reason why monetary policy cannot avert debt deflation is that asset prices are bid up to unrealistically high levels during booms based on the same "animal spirits" that govern investment. When markets turn then so do expectations which cannot easily be reversed and certainly not by monetary policy.

Financial innovation as described by Minsky leads to greater increases in asset prices during booms as it permits greater amounts of borrowed funds to flow into asset markets making asset prices more sensitive to the business cycle. As a result the risks of debt deflation during cyclical downturns increases over time. The reasoning behind this is simple - the ultimate effect of all financial innovation is to increase the level of debt relative to income. At the macro level this entails an increase in the debt to GDP ratio.

Therefore the Great Depression can be viewed as the natural course of the business cycle in economies subject to financial innovation. The full downswing portion of the business cycle can be forestalled by Keynesian counter-cyclical policy however this has to be accompanied by financial regulation. If not, financial innovation risks creating pro-cyclical swings in asset prices that will ultimately swamp Keynesian counter-cyclical policy.

Since 1980 we have witnessed the elimination or substantial reduction in almost all legislation governing the financial sector. This combined with disinflation and financial innovation set in motion a period of sustained increase in private credit relative to GDP. The foregoing suggests that an imminent recession could morph into an economic depression if it triggers debt deflation.

There does seems to be little doubt that Bernanke et al. believe that they can mitigate the process of credit contraction through monetary policy. There is an interesting question about the possible inflationary effects.

It is to be expected that Bernanke et al. have all thought about this, and would seek to mask the short term inflationary effects and the indicators of this very phenomenon described by Alex Grey of a sluggish broader money supply as compared to the narrow measures which are more amenable to monetary policy.

There is it seems a significant wild card which few seem to account for explicitly in the relative values of currencies and their impact on the import prices of economically important commodities.

We will be speaking more about this in the future. One of the slants on this that seems worth considering is the difference between the Japanese economic experience, which so many cite, and the Russian experience, which is qualitatively different and perhaps illuminating of important elements and differences therein.

LEH in Talks to Sell Asssets and New Equity to Raise Capital

Lehman may have to raise capital if sells assets
Mon Aug 4, 2008 12:48pm EDT
By Dan Wilchins

NEW YORK (Reuters) - Lehman Brothers Holdings Inc is expected to follow in Merrill Lynch & Co Inc's footsteps and sell a lot of risky assets at a loss. But shedding the assets may create another headache for Lehman -- the need to raise large amounts of new capital, including common equity.

Any capital raise would be painful for Lehman and its shareholders, given that the company just raised $6 billion in June and trades at a significant discount to its book value, or the net accounting value of its assets.

But Lehman, the fourth-largest U.S. investment bank, may have little choice as it wrestles with roughly $65 billion in mortgage-related assets, particularly after Merrill Lynch agreed to shed $30.6 billion in toxic assets at a fire-sale price of 22 cents in the dollar, analysts said.

"Lehman's caught between a rock and a hard place. They're getting more and more pressure from regulators and investors to add reserves or mark these things down," said David Hendler, an analyst at independent research firm CreditSights in New York.

"In normal times, they could wait it out, but the market wants it done now," Hendler added.

The New York Post reported on Friday that Lehman was talking to potential buyers about selling $30 billion in assets. CNBC television reported Friday that Lehman was in talks with BlackRock Inc to sell mortgage securities and other assets. Both Lehman and BlackRock declined to comment.

Lehman's chief financial officer told Merrill analyst Guy Moszkowski recently that the investment bank was willing to sell assets at a loss if the deal materially reduced risk, the analyst said in a report.

Lehman had roughly $65 billion in mortgage and real estate-related assets on its balance sheet as of May 31.

Selling at a loss seems increasingly likely after the Merrill deal last week. Lehman's assets may be of much higher quality, but Merrill's low sale price for mortgage-linked securities implies that many banks' assets connected to mortgages may be marked down further.

Lehman wouldn't have to sell assets at much of a loss before it had to raise capital.

Brad Hintz, an analyst at Sanford C. Bernstein, wrote in a note on Monday that any loss much greater than $1.5 billion -- which translates to selling $30 billion at a discount of at least a 5 percent to their current value on Lehman's books -- would likely force Lehman to issue at least some common equity.

Selling assets at enough of a loss would force Lehman to record a quarterly charge -- eating into capital for an investment bank that many investors already believe is undercapitalized. Any big reduction in Lehman's capital could bring pressure from regulators and rating agencies to raise capital.

Depending on the price that the assets are sold for, Lehman might have to raise $4.5 billion to $7 billion in capital to offset losses, CreditSights' Hendler said. Given that Lehman's market capitalization, or value in the stock market, is currently about $13 billion, such a capital raise could leave existing shareholders owning a much smaller portion of the company.

NEUBERGER UP FOR SALE?

If Lehman needs to raise more capital, it may consider selling all or a portion of its asset management business, analysts said -- a move mentioned in media reports as a possibility for weeks.

Investment banks have increasingly been looking to sell assets instead of issuing shares since shedding businesses that provide a relatively low amount of revenue may be less painful for shareholders than dramatically boosting outstanding shares.

Merrill sold back its 20 percent stake in Bloomberg LP, the news and financial data company, to Bloomberg Inc for $4.4 billion in July. It also said last month it was in advanced talks to sell a controlling stake in its Financial Data Services Inc unit, in a deal that could value the business at more than $3.5 billion.

Lehman's asset management unit, which includes the Neuberger Berman business that Lehman bought in 2003, generated about $1.88 billion in net revenue in 2007. Analysts estimate the unit could sell for about $8 billion.

Selling a business to raise capital may be better than issuing shares, but it is generally not pleasant, in part because getting a good price in a sale is tough now. Few buyers have the capital to make big acquisitions, and any potential acquirers know the sellers are anxious to sell assets.

Merrill Chief Executive John Thain told investors in June that he saw the Bloomberg business as worth between $5 billion and $6 billion, but the investment bank ended up selling it for less than that.

The Neuberger business is a steady generator of earnings for Lehman, which has helped stabilize Lehman's overall profits....

Citi Takes a Serious Hit on Credit Card Losses - Sees Defaults Rising

Citigroup Posts Loss on Credit-Card Securitizations
By Bradley Keoun

Aug. 4 (Bloomberg) -- Citigroup Inc. reported its first loss since at least 2005 on credit-card securitizations, signaling that risks may be growing in a business that generated $3.5 billion of revenue in the past three years.

The biggest U.S. credit-card lender lost $176 million in the second quarter packaging card loans into securities, the company said in an Aug. 1 regulatory filing. The New York-based bank completed fewer deals and was forced to mark down its own $9 billion stockpile of the debt instruments and other stakes the company amassed while selling them to investors.

Led by Chief Executive Officer Vikram Pandit, 51, Citigroup manages about $202 billion of credit-card loans worldwide, about $111 billion of which have been turned into securities and sold, according to the filing. Delinquencies on the securitized portion have jumped by 16 percent since the end of last year to $2.16 billion as of June 30, Citigroup said. The firm's results may portend similar losses for rivals.

Banks and other card issuers ``are predicting higher net charge-off rates across the credit-card industry,'' said Meghan Crowe, a Fitch Ratings analyst who tracks credit-card issuers including American Express Co., Capital One Financial Corp. and Advanta Corp. ``Things have been worse than anticipated.''

Citigroup spokeswoman Shannon Bell declined to comment. The company's shares fell 73 cents, or 3.9 percent, to $18.14 at 10:30 a.m. in New York Stock Exchange composite trading.

Jobs Cuts Spreading Throughout Much of the Economy

So much for the credibility of the ADP Jobs Report. Just How Accurate is the ADP Payrolls Report?

U.S. July Job Cuts Double Year-Earlier Level, Challenger Says
By Timothy R. Homan

Aug. 4 (Bloomberg) -- Job cuts announced by U.S. employers soared last month, led by reductions at airlines and financial firms, according to a report by a private placement firm.

Firing announcements increased to 103,312 last month, up 141 percent from 42,897 in July 2007, Chicago-based Challenger, Gray & Christmas Inc. said in a statement today. That's the biggest year- over-year percentage increase since November 2001, at the end of the last official recession.

Companies are trimming payrolls as fuel prices increase and the housing slump drags on. The Labor Department last week said that the U.S. economy lost jobs for a seventh straight month in July and the unemployment rate reached the highest in more than four years.

``We have seen job cuts increase in the majority of industries that we track,'' John A. Challenger, chief executive officer of the placement company, said in a statement. ``The downturn, which was isolated to the housing and financial sectors just a few months ago, has spread throughout much of the economy.''

Companies have announced a total of 579,260 cuts so far this year, up 33 percent from the first seven months of 2007, according to the report.

The number of planned job cuts rose 26 percent last month from 81,755 in June, the report said. The figures aren't adjusted for seasonal effects, so economists prefer to focus on year-over- year changes instead of monthly figures.

Transportation companies led industries in announced reductions in July, with 17,051. Financial firms followed with plans to eliminate 15,517 positions, and retail stores, which announced 12,160 cuts.