It's About Time for Confidence to Come Back

At this juncture in time, the economy faces two “systemic” near-term problems. First, the financial side the economy is very close to a “liquidity trap” – a situation in which conventional monetary policy loses all traction. Second, the real side the economy is in what Keynes called a “paradox of thrift” – when the entire private sector (businesses and households) tries to save more at the same time, it creates a downward spiral in business activities.

Neither one of the problems has a simple solution, yet both of them have something to do with a need for credit or liquidity creation. In the U.S., here are some ideas that economists proposed recently:

1. A massive fiscal stimulus package.
2. More monetary easing by pre-committing to keep the federal funds rate low for an indefinite period.
3. More direct interventions by the Fed and/or Treasury, including purchases of credit instruments and agency backed MBS to bring down private-sector borrowing costs.
4. Congress provision of authority to the Fed and/or Treasury to buy a broader range of risky assets as an extension of TARP.
5. Arrangement of guaranteed restructuring in Big-3 (or at least GM) in exchange for bridge fund.

Globally, monetary authorities are coordinating policy actions with four major pillars: liquidity creation, direct capital injection, purchase of troubled assets, and provision of guarantees.

Given time, some or all of the above measurements will work. At some point, collective expectation in the marketplace will recognize the facts that asset prices have been severely dislodged across all classes from their fundamental values and energy prices have now turned supportive to growth. It is also helpful to see some initial confidence given to the new administration and its economics team. It may be about the time for sentiment to find and form a bottom.

I think a constructive perspective should be valued and warranted. Here is why: Sentiment has been embarking a self-fulfilled downgrading process in recent months that may soon prove overdone. More importantly, liquidity is probably more a state of mind than substance in the current financial system as the derivatives portion is larger than traditional money supply. Yet valuation of derivatives is significantly influenced by confidence. Once confidence comes back, liquidity will come back as well, to an extent that it may even bring some upside surprises to what’s been factored in the current market consensus.

The U.S. economy is the most resilient in the world due to a mechanism of market oriented incentives and risk-taking nature of its participants. This has not changed. Despite 50 percent decline in stock market valuation over the past 12 months, homes are still the same homes; lands are still the same lands; companies are still the same companies; technologies are in fact improving, and most importantly, people are still the same people. This fact itself should instill some optimism.