LaSalle Economics, Inc
214-33 28th Ave
Bayside, N.Y. 11360
Tel # 1 718 224-3950
Email – vince@lasalle-economics.com
Dr. Vincent J. Malanga
President
Economic Commentary
October 05, 2008
For the record we’ll repeat a mantra from past Commentaries. Chairman Bernanke may soon face
his old nemesis, namely deflation. In 2002-03 his concern about deflation was misguided. After
all, how can there be deflation when asset prices are inflating. Well, there cannot be, but now
deflation is coming from all quarters. There is commodity deflation; real wage deflation; equity
market deflation; real estate deflation; and credit system deflation.
The Treasury’s Troubled Asset Rescue Plan {TARP} is in our opinion an ineffective approach to
addressing the real estate and credit system deflations. Instead of targeting real estate and credit
head on, TARP is meant to reactivate the credit system by removing toxic securities from the
balance sheets of financial institutions. Determining the right price for these securities is key. We
know less about how to do this than others who are undoubtedly working feverishly on this issue.
The goal of TARP is to purify balance sheets; boost financial institutions’ capital; and thus induce
institutions to start lending to each other and to step up money velocity by lending to the economy.
It does nothing to directly stabilize housing prices which is really at the heart of the entire global
credit crunch. So we think the real estate problem should be confronted head on and quickly.
Homeowners have negative equity amidst rising joblessness and declining real income and
negligible financial savings. Thus, consumption is being adversely affected. Inflation adjusted
consumer spending will have declined in the third quarter, dragging real GDP growth to zero at
best. As spending continues to falter and production is cut, real GDP is likely to drop sharply over
the next six months, perhaps at a negative 2% to 4% annual rate; far worse than current consensus
estimates.
One could divide the economy according to a pre and post September 15 timetable. This is the
approximate date of the Lehman bankruptcy, the AIG bailout, and some bank failures. Recent
increases in jobless claims to near 500k and September’s sharp decline in vehicle sales are mostly
pre September 15 phenomena. So too is the September jobless rate which held steady at 6.1%.
Data reflecting the post September 15 period is immediately ahead and it will be ugly.
Thus, it is now not a matter of if but when the Federal Reserve will cut interest rates. With other
Central Banks already beginning to cut and even the European Central Bank finally
acknowledging a concern over growth versus inflation, we think a coordinated rate cut will soon
be enacted. Hopefully it will be at least 50 basis points.
-2A rate cut would inject permanent liquidity into the banking system. It would steepen the interest
rate yield curve, and it would enhance bank profits. It would push mortgage rates down, making
housing more affordable, thus boosting demand and helping stabilize prices.
A rate cut is not enough in the current environment. The TARP allows Treasury to subsidize
mortgage rates offered by FAN, Fred, and the FHA. Since these entities are now under the
Treasury’s wing, the Treasury could direct them to grant forbearance. In other words they could
offer below market mortgage rates to new homebuyers as well as attractive refinancing rates to
existing owners who are in financial difficulty. This would keep people in their homes, reducing
the foreclosure rate. The effect would be to further the home value stabilization process.
Finally, the President and his two possible successors should join forces and propose a serious
fiscal stimulus program. From what we can see neither candidate’s current proposals are very
serious or stimulative. We would like to see the three get behind a halving of the payroll tax for
one year and then phased out over a three year period. This would be a boon to business, and it
would simultaneously get households back on track. Its beauty is that it is a simple program,
which probably immediately dooms its enactment. While the first two actions we have proposed
could be enacted immediately, tax changes will have to await the next Congress. However, if all
sides joined forces now, there would be an immediate psychological benefit.
Dangerous times require bold action. And these are dangerous times – so dangerous in fact that
we felt obliged to expand our normal one page Commentary!