20/03/2009: Brand-marked to market

If there is one profession that has an even duller and boring reputation than economists, it is accounting. So, who would have thought that in the current ongoing financial crisis one of the most passionate debates raging is about an accounting rule? Should we abolish or not mark-to-market accounting.

This rule stipulating that the value of an asset on a balance sheet should correspond to the current market price of the asset, or the price of similar assets. At a first glance nothing seems more innocent than this. Still, many experts believe that this rule has exacerbated market volatility and, if it has not caused the current financial crisis, at least deepened it.

How so? When the price of an asset starts to fall, it can lead to stress on the balance sheets of financial institutions forcing them to sell the assets to avoid further losses. But if everyone sells at the same time and there are too few buyers, the price of the asset becomes further depressed, precipitating even more forced selling and amplifying the downward spiral.

Acknowledging this problem in the US, the Emergency Economic Stabilization Act of 2008 (the bill that founded the Troubled Asset Relief Program, TARP) explicitly stated that the Securities and Exchange Commission (SEC) has the authority to suspend the mark-to-market rule if it determines that this suspension is in the public interest and protects investors.

However, there are risks to suspending or even abolishing this rule right now. First and foremost, such a measure could be interpreted by the public as a scheme to blur what financial intermediaries are holding on their balance sheets. In an industry shaken by trust issues, an increase in in-transparency is not something that would help to rebuild confidence.

Second, if some financial intermediaries continued operating under the mark-to-market rule while others used a different accounting rule, it could create a situation in which those financial intermediaries would appear to be hiding something, creating a two class sector and forcing in the end all financial intermediaries to stick to the mark-to-market rule.

Finally, financial analysts could, certainly would and in fact should (since it is their job) try to second-guess the balance sheets of those financial intermediaries who didn’t operate under the mark-to-market rule. By including this in their assessments of the financial solidity of a company, it would be a de facto continuation of the rule despite its official abolition.

While the suspension or a redefinition of the mark-to-market rule might make sense at a first glance to help increase stability in the financial system, it would be very difficult to implement at this juncture. Moreover, blaming an accounting rule for the ongoing crisis is a little bit like blaming the thermometer for having fever. No accounting rule whatsoever, can obfuscate the fact that bad investment decisions have been made for which a price is paid right now. While accounting might have become less boring, economics continues to be a dismal science.

06/03/2009: Deflation déjà-déjà vu

In 1998, then-Fed Chairman Alan Greenspan delivered one of his famously obfuscating speeches. The rather dry subject, “Problems of price measurements,” seemed unlikely to capture much media attention. But the appearance of the word “deflation” no less than eleven times did not go unnoticed.

Was the Fed afraid of a phenomenon unseen in America for half a century, the dreaded downward price spiral of deflation, with its suffocating effect on investment and employment? This view was reinforced by the Fed’s interest rate cuts shortly thereafter. In hindsight, however much they prevented deflation, the rate cuts of 1998-1999 also fed the stock and tech bubbles that followed. But, in 1998, deflation never materialized.

In 2002, then-Fed Governor Ben Bernanke delivered what would become one of his most famous speeches, “Deflation: making sure it doesn’t happen here.” The speech presented a catalogue of responses if deflation were to menace the US economy. It can serve today as a playbook explaining many of the Fed’s recent moves, including deep interest rate cuts.

But interest rates were kept too low for too long after the 2001 recession faded, and the cheap money fuelled the real estate and credit bubbles that plague us so painfully today. Deflation, however, again was vanquished.

Today, it’s “déjà vu all over again” as the Fed returns to battle the demon deflation, for the third time in a decade. But this time the fears may be well-grounded as we move further into a recession that could become the deepest since World War II.

For investors, the policies of central banks will be critical once the recession is behind us. Obviously, inflation-targeting, the core of modern monetary policy at all major central banks, has shown its limits. It can neither prevent “irrational exuberance,” as the tech, real estate and credit bubbles have shown, nor effectively fight off deflation when exuberance switches into panic.

How to improve central bank inflation-targeting in the future? We see two main possible approaches.

The first: broaden the target beyond inflation to include asset prices in order to puncture bubbles early in their formation. Of course, implementation would be problematic. For example, what distinguishes a bubble from a healthy market evolution?

Our second idea refers to a remark in Bernanke’s 2002 speech: to avoid deflation, the Fed should try to preserve a “buffer zone” for the inflation rate when the economy weakens. Given the Fed’s deflation stance over the past ten years, this buffer zone may now be too thin. It might be wise to set future inflation targets higher than they presently stand.

Ultimately, political considerations will shape future inflation-targeting. For investors, the answer to this policy question promises either lower but steadier average returns as the central banks try to curb market excesses, or higher long-term inflation. After the inflation-free bull run of 1982-2007, neither option is appealing. Then again, market crashes and deflation fears are far worse than either of these outcomes.