How Bad Could the Economy Get?

Before the meltdown, economists fell into two camps: those who thought the economy had already slipped into recession and those who thought a recession could still be avoided. While forecasters still differ on the timing and severity of a downturn, "the consensus view is that we're headed for recession and will be in one until next year," says Mark Zandi, chief economist for Moody's Economy.com.

Corporate profits are already on the verge of falling for a fifth straight quarter, according to Thomson Financial. The next shoe to drop will be consumer spending. "Two years ago, people were using their homes as ATMs, pumping out cash," says Robert Arnott, chairman of the investment consulting firm Research Affiliates in Pasadena. "As banks continue to tighten their lending, that spending is disappearing."

But softer profits and slower spending haven't translated into widespread layoffs yet. "This is the strongest recessionary job market in 40 years," says James Paulsen, chief investment strategist of Wells Capital Management. A jump in unemployment could still be coming, especially given bank and brokerage failures and mergers. But outside of finance and housing, much of the rest of the economy is strong, he says.

The weak dollar is boosting demand for our goods abroad, and lower gas prices are making Americans feel more flush. Add in the cash that the Fed has been hosing into the banking system and we are bound to see growth in 2009. "If all this stimulus has no effect on the economy, that would be a rarity indeed," says Paulsen.

Standard & Poor's chief economist David Wyss expects a mild recession that ends next spring. "Gradually we will regain confidence in the market. Lower oil prices and a falling trade deficit will help," he says. "This is a financial panic, not an economic one."

Of course, that could change if the financial panic doesn't abate soon. If banks remain too scared or broke to lend, would-be home buyers will be frozen out of the market. If that happens, home values could fall even more, crimping confidence and putting the brakes on the economy's greatest engine: the consumer.

How Did We Get Here From What We Were?

By now you likely know that the crisis in the financial markets is the culmination of years of reckless mortgage lending and Wall Street dealmaking. It's the final gasp of the burst housing bubble. But how exactly did this happen?

To find the root cause of Wall Street's woes, you have to go back to the collapse of a different bubble - tech. In 2001, after the dotcom craze ended and the bear market began, the Federal Reserve started aggressively slashing short-term interest rates to stave off recession. By eventually reducing rates to a historically low 1%, the Fed reinflated the economy. But this cheap money sparked a new wave of risk taking.

Homeowners, armed with easy credit, snapped up properties as if they were playing Monopoly. As prices soared, buyers were able to afford ever-larger properties only by taking out risky mortgages that lenders were happily approving with little documentation or money down.

At the same time, Wall Street investment banks got a brilliant idea: bundle the riskiest of these mortgages, then slice and dice these portfolios into tradable bonds to be sold to other banks and investors. Amazingly, bond-rating agencies slapped their highest ratings on the "best" of this debt.

This house of cards came down when subprime borrowers began defaulting on their mortgages. That sent housing prices tumbling, unleashing a domino effect on mortgage-backed securities. Banks and brokerages that had borrowed money to boost the impact of those investments had to race to raise capital.

Some, like Merrill Lynch, were forced to sell. Others, like Lehman Brothers, weren't so lucky. "What we always tell investors is beware of too much leverage in a company," says Brian Rogers, chairman and portfolio manager for T. Rowe Price. "Leverage is the enemy of the investor."

Sure, everyone from former Fed chairman Alan Greenspan to your friends and neighbors played a role in stoking this casino culture. But troubled banks and brokerages can't pass the blame. "These firms closed their eyes and made very bad bets on risky securities that they didn't truly understand," says Jeremy Siegel, finance professor at the University of Pennsylvania's Wharton business school. "Investments that they did not have to make led to their demise."

A Plausible And Yet Probably Way Of Driving Us Out Of Stagflation ll

According to the law of comparative advantage, even if Malaysia has an absolute disadvantage in the production of goods for export with respect to other third world countries like China, there is still a basis for mutually beneficial trade. But how you may ask, can Malaysia export anything to China if it is less efficient than China in the production of these goods? The answer is that the technological innovations in Malaysia might be significantly higher than our Chinese counterparts. It will enable Malaysia to engage in high value added ventures that make use of more advance technical innovations in the production of such goods at a cheaper rate where it will attain the economies of scale from the production landscape in China. On the other hand, wages in China will be significantly lower than wages in Malaysia so as to make the price of high tech goods (the commodity in which Malaysia has a comparative advantage) lower in Malaysia, the wages in China lower in China when both commodities are expressed in terms of the currency of either nations.

This is the case where China by itself is experiencing relatively high unemployment in its absolute terms (due to its large population mass) even though its unemployment rate is low in relative terms compared to some western countries. This simply means that China has excess capacity in its labour forces which has not been harnessed in the first place. If its human resources are properly allocated for efficient use, it should be in the position of providing exporting nations with relatively cheap and amble labour.

A Plausible And Yet Probably Way Of Driving Us Out Of Stagflation l

Stagflation is defined as a systematic slow down of an economy as it is also accompanied by a condition of uncontrolled price hikes. Many felt that this situation could not last forever where the government had announced a host of budget concessions in our budget lately to relieve the hardship of our people. Such tax reliefs, rebates together with concessions are not sufficient to patch our economic woos up; rather it merely helps our lower and middle income taxpayers to put back more of the disposable income into their pockets.

Perhaps the application of game theory in itself might be well at our disposal of providing us with a remedy; a solution that will drive our nation towards sustained economic independence and integration. In recent years, some economist like MIT's Paul Krugman have argued that governments by supporting their companies in international competition, may be able to raise national welfare at another country's expense. This is usually accomplished through capacity expansion or with the assistance of subsidies. The decision of whether – and if so, how much – to expand production capacity is one of the most important strategic decisions made by companies. Some companies adopt a preemptive strategy that is, they try to expand before their rivals do, thus discouraging their rivals from building extra capacity of their own. If the future growth of demand for a particular product is known with reasonable precision, such a strategy may be effective.

Such preemptive strategy can be adopted in light of the rising utility overhead as a result of price hikes for fuel. Malaysia might need to look into the possibility of adopting the usage of alternative energy substitutes against the reliance on crude oil as its price has risen in a more or less ricocheting fashion. Owing to the fact that Malaysia is progressing towards an industrialized nation, utility overhead has far out stripped labour wages in terms of its greater sizable share in the composition of our production costings nowadays. The recent increase in our energy tariff makes it more prominent so to speak. Given that a cheaper fuel substitute is used for generation of power, this enable us to deliver cheaper utility rates to consumers. A cheaper utility rate implies longer machine production hours which is the case where most of the production high value added goods are no longer labour intensive rather capital intensive in nature. However, this might require concerted efforts both from the initiative taken by the government and our independent power producers in the quest for cheaper and more sustainable energy consumption. Through a lower rate of energy consumption, this enables our nation to produce more goods at a cheaper rate and thus improving our international pricing competitiveness. An improved competitiveness in the production of goods strengthens our trade surplus and thus bridging the gap in our nation's balance of payment in the future.

The Interaction Of Market Disequilibrium And Price Dynamics: A Boom/Bust Sequence In Financial Market

It has long been shown that most of the major market fluctuations have been predisposed to certain degree of market disequilibrium as advocated by Soros himself which the rational expectation model fails in explaining such phenomenon. With reference to the classical properties cycle as it has happened in US now, the market is spurred by growing optimism that has yet to be justified in the initial phase of such cycle. In other words, people are not solely buying on valuation basis but most importantly on the perception that they could reap attractive capital gains from their property arbitrages. This exerts an upward pressure on the property prices as a result of the underlying demand for properties itself.

Morever, it has also created a spilled over effect on the demand for their factors of production (ie raw material, labour and utility overhead) and hence causing their respective prices to rise in an upward spiral. Producers may even slow or control the production of these factors of production in anticipation of future price hikes that would eventuate some day. This is often self-perpetuating to such an extent that it exacerbates the rate of inflation growing in the near future. The inflationary effect attributed from the demand for properties and the cost pressure from building materials, labour wages and rising utility overhead further create a multiplier effect on the prices of goods and services across the board until prices reach to a level that could not be sustained anymore. Eventually, inflation will take its toll on the everyday living of the people.

Most central banks might even rise their key interest rate in order to keep the inflationary environment under control. The interest rate hikes itself may erode both realised and unrealised capital gains from property arbitrages because of the fact that home owners are made to shoulder additional mortgage charges in excess of what they really could afford. They might even find that these arbitrages are becoming harder and harder to execute as the liquidity of property market runs dry; a typical situation when prices rise too fast and too steep.

Inflation by itself will act as an implicit tax to our tax payers' pocket in the sense that it forces them to pay more for the usual basket of goods and services then before. It dampens consumer spending and affects growth in an economic system at large. If the inflation condition has coincided with a slow down in economic growth as we might experience right now (as a result of the situation mentioned above), recession will eventually set in.

At this point, this is where the investment and consumption confidence of the people collapse giving way to relentless price cuts in attempt to entice more deals in an already growth stifled environment. On the other hand, people will hoard more cash for future contingencies and less on consumption spending and investment; as a classical instance where rational expectation plays out a self-adjusting and reinforcing process on peoples' consumption and investment behaviour. Cost cutting measures are also put in place in order to enhance the competitiveness of economies in the production of goods and services. As peoples' ability to produce cheaper goods and services increases, this enables them to accumulate more wealth in terms of their ability to churn out greater value of good and services for the economy. This in turn translates into greater purchasing power for the people while the inflation condition is therefore reversed paving the way to a sustained economic recovery.

Flaws In Rational Expectation: A Blessing In Disguise II

Why are the flaws in rational expectation model considered as a blessing in disguise? According to Soros, people regardless of how rational they might seem, are in actual fact dealing with incomplete information in an imperfect market nowadays which leads them to develop lop-sided views on where the actual market is heading. This imperfect understanding about the market forces causes poeple to engage in different betting or hedging positions for any underlying financial instruments in any financial markets which in turn induces active market participation at the end of the day. This creates more trading opportunities as well as liquidity for market participants in general. The way to make money as perceived by Soros is to look for ways to capitalize on these vagaries in betting positions, to identify and search for the unexpected developments that associate with the opposing market positions and bet on it.

Flaws In Rational Expectation: A Blessing In Disguise I

Despite being said about the explainatory validity of rational expectation in addressing peoples’ formation of expectation based on available market information, it is too costly in gathering this typical information which is supposedly not readily available to the ordinary people. Even though the so-called optimal forecast (best guess of the future) is the best that closely represents the actual situation, it might be even too expensive to achieve in its entirety. The rationale is that the future cannot be predicted, so that no expectations can be truly “rational”.

Owing to the fact that people are neither perfectly rational nor perfectly informed, it is unreasonable to believe that business owners generally fix their prices with reference to the macroeconomic trends. It might be difficult to get hold of current information on the Federal Reserve's rates and policies as well as the inflation and unemployment rates or even the nation's GDP growth. Even more improbably, how would the people set their budget, prices and wage demands by these indicators accordingly and accurately? This leads the market to have reacted in disequilibrium as opposed to the suggested one and only market equilibrium in rational expectation; as empirical evidence shows that income does not rise in tandem with the escalating cost of living lately.

Lastly, the application of rational expectation hypothesis fails to account for human behaviour in its totality. It simply means that individuals might not draw behavioral references from the prescribed norm that is representative of the group behaviour. People have mixed views and are just biased right through their skins!!! “…..Even if all individuals have rational expectations, the representative individual describing these behaviours may exhibit behaviour that does not satisfy rational expectations (Jansen 1993). In other words, they might have reacted differently given the same set information available in the market place.

Extrapolations have been made from these perceived weaknesses of the rational expectation model, will be discussed in full details later…..

Rational Expectation: A Paradigm Shift

Owing to the limitation of adaptive expectation principle in modeling peoples’ expectation about the future economic conditions based on past experience, the assumption had been relaxed to accommodate the proposition that people form their expectations by making use of all the available information in the market in such interference on these economic conditions is drawn. The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be (the market equilibrium results). The concept is motivated by the same thinking that led Abraham Lincoln to assert, "You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time." It does not deny that people often make forecasting errors, but it does suggest that errors will not occur at random order. (Rational Expectations, Thomas J. Sargent)
In the rational expectation model, the actual price denotes as P is the equilibrium price in a simple market, determined by supply and demand. The actual price is equal to its rational expectation as shown as follows:

P = P* + e; e = 0
E(P) = P*

where P* is the rational expectation and e is the random error term, which has an expected value of zero, and is independent of P*. The rational expectation model suggests that the actual price (P) will only vary from the expectation if new set of information of unforeseen nature prevails in a simple market (e). The rational expectation hypothesis draws attention to the way people make decisions by taking all available information into consideration as it is also strongly purported in the efficient market hypothesis (efficient market theory). In a situation where the price of shares does not reflect all the information about it, then an arbitrage opportunity arises; people can buy (or sell) the security to make a profit, thus pushing the price towards equilibrium to the extent that the profit margin will be squeezed to zero. In this instance, all prices are accurately representative of the current market fundamentals (ie capital gains and dividend streams in the future) as they have reflected information about their true values.

Dawn of expectation theories

Most of the contemprorary economic models involving the interference of individuals’ perception towards decision making were first derived from the adaptive expectation principle which holds that the future value of economic variables like economic growth, interest rates or inflation can be projected based on past figures inclusive of their margin of error. This simply means that past figures have crucial bearing over future figures unless new set of figures prove otherwise. However, adaptive expectation principle has not been able to account for the ever changing variables and concentrates only on past trends to such an extent that the proposition was abandoned in the early study of hyper inflation.

Let’s us explain this fact in light of the dividend growth model,

Po = [Do x (1 + g)] over (r -g )

Po denotes as the share price at period 0

Do denotes as dividend payout at period 0
g denotes as growth rate
r denotes as interest rate

The proposition suggests that share price is determinant of its dividend payout (Do) growing at a factor of g discounted by the real interest rate (r – g) which is also known as the interest rate adjusted for inflation.

In real life, the dividend growth is pretty much affected by the GDP growth of the economy where dividend growth [D0 x (1 + g)] is a function of GDP growth. On the other hand, the interest rate has an inverse relationship with dividend earnings that implies a higher interest rate erodes profits and hence dividend earnings distribution in terms of having a higher borrowing cost serviced. The interest rate variable is primarily determined by the current state of inflation so to speak; a higher interest rate is needed to curb a higher state of inflation. Empirical evidence also shows that a higher growth rate correlates with a higher level of inflation and thus interest rate might be rise to keep inflation at bay. All these factors are intertwinely fluctuating or even at times evolving on their accord. Hence, the adaptive expectation principle fails to explain the complexity of these economics indicators as progress over time.