Thursday, March 6, 2008

Shifting Gears

If you ask me, I’d say there are two personality types: Those who drive automatic cars and those who prefer stick shifts. Frankly, I never understood America’s fascination with the former. True, you may well need a free hand to talk on your cellphone, drink your coffee or stroke your partner’s earlobe. But, surely, none of these is as fun as the sense of empowerment your get with a stick-shift!

Among the recent converts to manual transmission is Fed Chairman Ben Bernanke. Just over two years ago, Ben gazed languidly at his automatic and decided he had enough. “Enough theorizing about transmission mechanisms,” he said. “Time to lay my hands on a shift knob! And what’s the big deal about earlobes anyway?”

It was around the same time, January 2006, he was appointed at the helm of the Federal Reserve, in charge of monetary policy. And just as he was flirting with an old convertible Chevy Camaro, he dumped her on the spot: “Who needs a stick shift when I get the entire American economy to play with?”

A driver’s manual: Arguably, the conduct of monetary policy is akin to driving a car—ok, maybe a touch more complicated. Cars need a transmission to ensure that, as the car accelerates or slows down, the engine continues to deliver its best performance (basically stay near its optimal rpm) instead of, say, exploding! Similarly, when it comes to steering an economy, the objective of monetary policy is to ensure that the economy operates at “full employment” without “overheating” or spiraling into deflation.

So how does monetary policy work?

Broadly speaking, the conduct of monetary policy relies on two things: A set of instruments to implement it; and a “transmission mechanism” that can deliver its desired consequences. You can think of the former as a car’s shift knob, though economists will tell you the first think that comes to their mind is the short-term interest rate. Here I will focus on the transmission mechanism.

Lowering gears: Think of the slowing American economy as Ben’s dream Chevy trying to go uphill. As the car slows, a “seasoned” stick-shift driver will instinctively lower gear—else, as the driving wheels revolve more slowly, the engine’s rpm will drop to suboptimal levels and so will the horsepower. The process relies on system of interconnected shafts, gears, synchronizers, collars, etc, which spin, turn, synchronize, engage and disengage.

Now despite Ben’s inexperience with stick shifts, he had read and written a lot about how transmission mechanisms work. So as the economy began to lurch uphill last year and, while at it, kept on stumbling onto all sorts of holes (from “subprime” defaults to ailing banks to plummeting stocks), he took one last look at the driver’s manual and… lowered gear! He cut the short-term interest rate hurriedly and brutally in the hope that one or more of the following channels would help rev up the economy.

Cheaper borrowing: First, a lower short-term interest rate should translate to lower interest rates across longer “maturities.” Long-term rates apply to mortgages or to companies’ investment decisions, and therefore a decline in their levels should encourage fresh borrowing and boost demand for cars, homes, I-phones etc.

Wealth boost: A lower interest rate could also help raise the price of different assets—e.g. shares, bonds or real estate. This is because of the way asset prices are calculated (e.g. in the case of a stock, its price is the “present value” of the company’s expected future cashflows, which increases the lower the interest rate). So with the prices of your stocks or your home higher, you feel wealthier and start consuming again.

Containing collateral damage: Come on, you know this channel already! (See “Hit by a fat tail”). But as a refresher, as lower rates help raise the price of your home, the value of the collateral you can use to borrow from a bank increases. Suddenly you have become a wealthier, “safer” borrower, banks demand a lower premium to lend you money so you borrow more and consume more!

Hammering down the dollar: It may be hard to believe, but a plummeting dollar may not be necessarily as bad as it looks. True, those weekends to Paris are long gone but American exporters are beginning to benefit as their “made in America” stuff (yes, there’s still some of that left!) is regaining its competitive edge abroad.

An uphill struggle: Yet, despite the lower gear, Ben’s Chevy is still struggling. And I’d say it’s not because Ben was a rookie with stick shifts. True, he let the economy “coast” for a while and, by the time he lowered gears, it had already lost some precious momentum. But that should not be as serious a problem: Even if a car stops uphill, you can always lower to first gear and start it back again. (Just don’t forget the handbrake!)

The main problem is the transmission mechanism is not working properly. And, arguably, that's partly thanks to the Chevy’s previous owner, Alan Greenspan. You see, the former Fed Chairman was an “exuberant driver” on occasions, with a knack for high speeds at low gears, and parts of the transmission mechanism wore out a bit.

Banks first and foremost, which are critical in facilitating the resumption of credit to households as rates go down. But after years of reckless lending, their balance sheets are overloaded with junk investments they can’t get rid of; so their room for new lending is limited.

But there is more. With the full extent of bank losses still unknown, and new “landmines” exploding day by day, uncertainty is plaguing credit markets and borrowing risk premia have shot up. On top of that, a falling dollar has raised commodity prices and inflation expectations. Both of these have worked to raise long-term interest rates, even as Ben is pulling the short-term rate down.

The economy needs more than just a skilled driver at this stage; it needs to have its transmission mechanism fixed. Else, even first gear won’t stop it from coming to a standstill and start sliding backwards. And Ben, if that happens, don’t ask me to come out and push!

Glossary: Transmission mechanism, full employment, short-term interest rate, present value, revolutions per minute (rpm), Chevy Camaro, earlobes.

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