Greg Mankiw had a great article last weekend in which he challenged the view that macroeconomists have learned enough to prevent a repeat of the Great Depression. Greg notes some disturbing similarities between our current difficulties and the problems of the 1930s:

From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today. The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks. As they withdrew their funds, the banking system's normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households' debts....

Deflation across the economy is not a problem (yet), but deflation in the housing market is the source of many of our present difficulties. With so many homeowners owing more on their mortgages than their houses are worth, default is an unfortunate but often rational choice. Widespread foreclosures, however, only perpetuate the downward spiral of housing prices, further defaults and additional losses at financial institutions.

Greg is certainly correct that house price declines have a potential to cause similar problems today as we saw in the 1930s. But I believe it is more than an academic distinction whether we are talking about a relative price change (house prices go down but the dollar price of most other items goes up) or a true deflation (the dollar price of almost everything you buy goes down). The reason is that the latter problem is absolutely one that the Federal Reserve could fix, whereas the former problem may not be.

In a general deflation, the purchasing power of a dollar bill goes higher and higher, and as Greg notes, this can produce big economic problems, as it did for the U.S. in the 1930s or Japan in the 1990s. But it is absolutely a problem that the Federal Reserve can fix. If you increase the quantity of dollar bills fast enough, you're sure to create inflation, not deflation. And the Federal Reserve has unlimited power to increase the quantity of dollar bills.

Some of my colleagues still talk of the possibility of a liquidity trap, in which the central bank supposedly has no power even to cause inflation. Their theory is that interest rates fall so low that when the Fed buys more T-bills, it has no effect on interest rates, and the cash the Fed creates with those T-bill purchases just sits idle in banks.

To which I say, pshaw! If the U.S. were ever to arrive at such a situation, here's what I'd recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we're at it! Print an arbitrarily large quantity of money with which you're allowed to buy whatever you like at fixed nominal prices, and the sky's the limit on what you might set out to do.

Of course, the reason I don't advocate such policies is that they would cause a wee bit of inflation. It's ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we're flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

Notwithstanding, I think Greg is raising a very valid point. Allowing the overall deflation in the U.S. in the 1930s and Japan in the 1990s was one quite fixable policy error. But perhaps modern macroeconomists have deluded ourselves into thinking that if this policy error had not been made, the whole episodes could have been avoided. How bad would the Great Depression have been if the price level had not fallen? Not as bad as it was, I'm convinced, but maybe still pretty bad.

I still like Brad DeLong's perspective on all this:

Is 2008 Our 1929? No. It is not. The most important reason it is not is that Bernanke and Paulson are both focused like laser beams on not making the same mistakes as were made in 1929....

They want to make their own, original, mistakes..

Technorati Tags: macroeconomics, economics, Federal Reserve, deflation, Great Depression, liquidity trap

The Singapore Exchange Limited (SGX) set a record in exchange-traded funds trading volume in September, with almost $323 million, or a 4% increase over the previous record of $311.3 million set in March 2008.

Volume of 38.2 million shares in September was also 7% higher than the previous record of 35.7 million shares. The total value of ETFs traded on the SGX reached $2.2 billion through the first 9 months of the year, a 277%, or $584 million, increase over the same year 2007 period.

Similar to the domination of a handful of large ETFs in the U.S., such as SPY and QQQQ, the trading and volume increases in Singapore have been driven by a few large ETFs -- iShares MSCI India ETF, Lyxor India ETF (Nifty) and SPDR Gold Shares, no surprise in the case of the latter portfolio, as gold investments have amassed record assets worldwide during  September's market turmoil.

Another notable development behind the recent trading of ETFs in Singapore was the introduction of the first broker-produced ETF portfolio allocation and research reports in July.

At the same time, new ETFs are debuting on the Tokyo Stock Exchange and Hong Kong Exchange.

In Tokyo, the first-ever commodities ETF in the market is to launch on Oct. 22, pegged to the S&P GSCI commodities index. While the commodities market has been beaten down in 2008, commodities-based ETFs have been an important part of the long-term ETF asset growth story in the U.S., including the iShares $700 million S&P GSCI ETF (NYSE: GSG). The new commodities ETF in Tokyo will raise the total number of ETFs trading in Japan to 59 portfolios.

In Hong Kong, the biggest Taiwan-listed ETF, and one of the largest ETFs worldwide, is set to list on the Hong Kong Exchange in January. The Polaris Top 50 Tracker Fund tracks the TSEC Taiwan 50 Index, the 50 largest companies in Taiwanese market. The existing Hong Kong-listed ETF ranks among the 25-largest ETFs globally.

Barclays Global Investors caught the attention of the market last week with its hiring of Deborah Fuhr, arguably the most well-known among analysts tracking global exchange- traded funds markets.

The former Morgan Stanley strategist announced September 7 that she's moving from one of the world's largest brokerages to Barclays Global Investors, the ETF industry's biggest player. (See related story.)

Fuhr started her new job this week as BGI's global head of ETFs research and implementation strategy. Even though she has been busy  assembling a new staff and preparing for her new position, Fuhr took time out from her busy schedule recently to talk to IndexUniverse.com's Eric Rosenbaum about the move to BGI and its implications.

IndexUniverse.com (IU): Will you be moving to BGI's headquarters in San Francisco for your new position or remain in London?

Deborah Fuhr (Fuhr): Being based in Europe is much better. This is a position where my team will need to be able to cover the global ETF market. Just in terms of time zones, London is a better base, allowing better communications with Europe, Asia, the Middle East and Latin America, for example. There are other reasons, too, tied to the nature of the exchange-traded product market in countries outside the U.S.

For example, outside the U.S., private placement exemptions allow greater flexibility for investors to use a wider array of exchange-traded products, and we will be covering these products.

At some point, as the research team grows, it might make sense to have members based regionally, but at this point, I can only tell you that we expect to start with a team of three, including myself, based in London.

At Morgan Stanley, clients asking our advice on how to implement new exposures using ETFs took up a good deal of our team's time, so we will see how that work develops.

IU: You mention your coverage territory being global. How do you view the world of ETFs? Is there more convergence or divergence between various markets at this stage of the industry's evolution?

Fuhr: Clearly, what's happened with the industry on a global level is that the ETF providers are now able to create products that are similar across multiple markets, but that are still often quite different from a regulatory and tax perspective. They're also differing levels of counterparty exposure as well.

The bottom line is that the need for clarity and education is higher now. Before, the providers tended to follow the same structure with products, and when we were talking about an ETF, we knew it really was an ETF. That's not the case anymore. Now people say "ETF," but apply it to products that aren't funds and that aren't transparent, that don't feature in-kind creation and  redemptions or have multiple broker dealers trading, and that are not tracking indexes or offering real-time indicative NAVs.

IU: Will you set out to tackle this confusion directly through your new position?

Fuhr: My new position is an opportunity to cut through all this confusion and try to begin a discussion about creating a set of understandable definitions to help advisors and investors understand exchange-traded products. In the U.S., many people still lump together closed-end funds, HLDRs, exchange-traded notes, and ETFs without understanding the tax and regulatory implications. Just take the closed-end fund discount and premium dynamics and the fact that closed-end funds do not track indexes, as one example.

I see a real need to develop a set of industry standards. There are still many investors coming into the ETF market specifically as a way to explore alternative asset classes and to use new benchmarks. BGI is a good platform from which to begin a dialogue with all the stakeholders in this exciting asset class, managers, exchanges, market makers and investors

This is a big change for me. Being at BGI means that what I produce can be shared with many brokers, and other financial services firms, whereas previously the nature of my work was more limited by the proprietary brokerage firm model.

IU: Is there any investor base, in particular, for which you see the greatest need for industry standards and cutting through all the product proliferation and clutter?

Fuhr: In the U.S., retail investors have continued to embrace ETFs. When you move outside the U.S., though, ETFs are primarily an institutional product, with a few exceptions—such as South Africa, where there are certain exemptions to exchange control policies which allow retail investors to access foreign index products. Generally, the rest of world is much more institutional in its use of exchange-traded products. So the institutional client outside the U.S. is a very important user group for ETFs.

If you look at July-ended data, global assets in ETFs are down slightly year-to-date, but European-domiciled ETF assets are up 24.4%. And if you compare asset inflows to mutual funds in Europe versus inflows to ETFs, the ETFs had positive inflows, whereas mutual funds had significant outflows. This goes back to the institutional investors in Europe embracing the exchange-traded fund structure, and that will continue.

The search for low-cost beta products to implement tactical allocation makes ETFs an appealing product.

IU: Do you think the opportunities for growth outside the U.S. are greater than within the U.S.?

Fuhr: The growth in tactical asset allocation and changes in regulations in Europe allow construction of funds that can invest in other funds, so we have funds of funds using ETFs, family offices using ETFs, as well as private banks.

Europe still has a long way to go in terms of growth, and I would note that we haven't even seen significant use of exchange-traded products by the retail investor sector in Europe yet. Asia and China is a large opportunity, and in the Middle East, there is considerable interest in developing an ETF market, and Latin America presents a growing opportunity. So yes, in many respects, there is more opportunity outside the U.S. That said, BGI has a large, well-established team in the U.S., and there are still opportunities for growth in the U.S., but the rate of growth will be higher in other markets.

As far as how my research team's focus will be delineated, I have to stress that we still need to sit down with  the CEOs from each region and agree on a plan of how my team can help in each market, and which markets, in particular, should be given greater focus in terms of client interaction.

IU: You alluded to the importance of developing industry standards as a primary focus for your team, regardless of particular markets. Do those definitions need to be global?

Fuhr: Trying to create industry standards begins with definitions for ETFs, ETNs, ETCs and exchange-traded products. Working through these definitions, and differences, will be an important part of taking ETFs to the next level, and involves transparency on the tax and regulatory issues I alluded to earlier.

And yes, it is a global effort. When we take this view of the world, we see the need for consistency of definitions, so no matter where an exchange-traded product is being used, its definition is the same. Many exchanges are now cross-listing ETFs from various countries. Japan is encouraging ETF providers to cross-list ETFs from Europe on the Tokyo Stock Exchange, for example, while the Mexican Stock Exchange already lists many products from other jurisdictions. Ultimately, the need for consistent definitions and transparency is critical for institutional and retail markets.

To date, there is no global ETF trade organization. Some existing mutual fund associations, such as the Investment Company Institute (ICI), are looking at ETFs, but I think it is still early days in terms of industry standards. It will require a combination of working locally as well as globally with all of the constituent firms.

And I think because no one company, or type of company—whether index provider, asset manager, broker or market maker—has every product to make available to clients; this is an issue about which all parties should be interested in working together to resolve.

IU: Given the rapid growth of the ETF space and the proliferation of product types and asset classes, is your new position at BGI one that you could have even imagined existing a few years ago?

Fuhr: I don't think so. The lines are really blurring. Many issuers of ETFs are also brokerage firms, so there have always been researchers writing reports, but they have tended to focus on one country or region.

When I started working with ETFs in 1997, there were 21 ETFs and $8 billion invested. In the early days when I talked to investors, they would say: "I'm an active investor, so I have no interest in index products," and others would say, "unless you are planning to pay me rebates, please go away."

The resistance was great, but now ETFs and exchange-traded products have been accepted both by retail and institutional investors—and by active as well as passive investors—as a useful tool and alternative to futures and program trading, among other instruments and trading strategies.