How to avoid the horrors of ‘stag-deflation’

Nouriel Roubini writes in FT an Op-ed, "How to avoid the horrors of ‘stag-deflation’"

The U.S. and the global economy are at risk of a severe stag-deflation, a deadly combination of economic stagnation/recession and deflation. A severe global recession will lead to deflationary pressures. Falling demand will lead to lower inflation as companies cut prices to reduce excess inventory. Slack in labor markets from rising unemployment will control labor costs and wage growth. Further slack in commodity markets as prices fall will lead to sharply lower inflation. Thus inflation in advanced economies will fall towards the 1 percent level leading to concerns about deflation. The worst is not behind us: 2009 will be a painful year of a global recession, deflation and bankruptcies. Only very aggressive and coordinated policy actions will ensure the global economy recovers in 2010 rather than facing protracted stagnation and deflation.

For more click on this link.

October employment report.

The October employment data has reignited fear that things are going to get vey bad. According to the Bureau of Labor Statistics (BLS), nonfarm payroll employment fell by 240,000 in October. BLS also report that job losses over the last 3 months totaled 651,000. In October, the unemployment rate rose from 6.1 to 6.5 percent, and the number of unemployed persons increased to 10.1 million.
WSJ has more on the latest figure. Click here.
"Today’s jobs report offers more evidence that the economy is in the midst of a downturn that will not only be deeper than the recessions that ended in 1991 and 2001, but may approach, or perhaps surpass, the severity of the long recession that ended in 1982."

Commercial Paper Market Still Shrinking

The WSJ has a piece showing that the Commercial Paper market is still shrinking. See the chart below.

This view contrasts with that shared in a post on Krugman's blog that suggests that the money markets are unfreezing.
Scott commenting on Kruman's post writes "As recently as Friday, I heard three different people in the industry describe the LIBOR rate as “notional” or “fictional”, and state that everyone was still largely hoarding cash, even among the banks. The transactions are apparently not happening at a sufficient volume to clear the market, regardless of the offered rate. I’ll believe that the markets are thawing when I hear the ice crack. "
Seems to me that Scott heard right.
The big problem in the money market for the US seems to be the weak economy. WSJ states "What’s worrisome, though, is that the decline in short-term commercial paper issuance may not reflect as much on the clogged money markets as it does on economic weakness. "

The US tax payer is indeed getting a lousy deal for his $125 bn capital injection

Willem Buiter agrees with Uwe Reinhardt's article that suggests that the US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks. I agree with both of them. Paulson's bailout gift is blatantly unfair to tax payers and the action creates a moral hazard problem that could destablize the US financial system someday in the future.

The US tax payer is indeed getting a lousy deal for his $125 bn capital injection
Uwe Reinhardt is absolutely correct. The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks. This is surprising to me, because the complete or partial nationalisations of a number of US financial behemoths earlier in the year represented rather better value for money for the tax payer.
The nationalisation of Fannie, Freddie, AIG and pieces of the nine largest US banks (with more to come) was necessary to prevent a complete collapse of the house of cards we used to know as the American financial system.
Unfortunately, Treasury Secretary Hank Paulson’s injection of $125 billion into the nine banks (out of a total capital injection budget provisionally set at $250bn (but bound to rise to probably around twice that amount), carved out of the $700 bn made available (in tranches) by the 2008 Economic Stability Emergency Act, was almost a free gift to these banks. In this it was different from the case of AIG, where the Fed and the Treasury imposed rather tough terms on the shareholders and obtained pretty favourable terms for the US tax payer generally. It was also unlike the case of Fannie and Freddie, where the old shareholders are likely not to recover anything.
In the case of the Fortunate Nine, the injection of capital is through (non-voting) preference shares yielding a ridiculously low interest rate (5 percent as opposed to the 10 percent obtained by Warren Buffett for his capital injectcion into Goldman Sachs). Without voting shares, the government has no voice in the running of these banks. It also has no seats on their boards. By contrast, in the Netherlands, the injection of €10bn worth of subordinated debt into ING bank comes with a price tag that includes two government directors on the board and a government veto over all strategic decisions by the bank.
In addition, in the the case of the Fortunate Nine, there are no attractively valued warrants (options to convert, at some future time, the preference shares into ordinary shares at a set price or at a price determined by some known formula). Quite the opposite, the preference shares purchased by the US state, can be repurchased after three years, at the banks’ discretion, on terms that are highly attractive to the banks. The US tax payer is not only getting a lousy deal compared to private US investors like Buffett, (s)he is also doing much worse than the British tax payer in the UK version of Paulson’s capital injection (£37 bn so far out of provisional budget of £50bn). The UK preference shares have a 12 percent yield and come with government-appointed board members.
Even in the cases of AIG, Fannie and Freddie, unsecured senior creditors did not have to take an up-front haircut. Worse than that, even holders of junior debt and subordinated debt could come out of this exercise whole. There were no up-front haircuts, charges or mandatory debt-to-equity conversions.
That, I would argue, is scandalous, both from a fairness perspective and from the point of view of the moral hazard this creates, by boosting the incentives for future reckless lending to elephantesquely large financial enterprises. Unless not only the existing shareholders of the banks benefiting from these capital injections but also the holders of the banks’ unsecured debt (junior and senior) and all other creditors of the bank (with the possible exception of retail depositors up to some appropriate limit) are made to pay a painful penalty for investing in excessively risky if not outright dodgy ventures, we are laying the foundations of the next systemic crisis, even as we are struggling to escape from the current one.

Bernanke at Economic Club of New York

Chairman Ben Bernanke spoke at the Economic Club of New York earlier today. He said government efforts to calm financial markets and stem the credit crisis probably won't result in an immediate economic rebound. Craig Torres reports on the speech here.

World Economic Outlook- Global Economy Under Stress

IMF World Economic Outlook (WEO) - Financial Stress, Downturns, and Recoveries, October 2008 is out. You can find it here. The Executive Summary notes:

The world economy is entering a major downturn in the face of the most dangerous financial shock in mature financial markets since the 1930s. Global growth is projected to slow substantially in 2008, and a modest recovery would only begin later in 2009.
Inflation is high, driven by a surge in commodity
prices, but is expected to moderate. The situation is
exceptionally uncertain and subject to considerable
downside risks. The immediate policy challenge is to
stabilize financial conditions, while nursing economies
through a period of slow activity and keeping
inflation under control.