No Need to Dread a Prudent Fed
I am somewhat surprised that after having been head-faked by the fraud in France, people aren't a bit more anxious about whether or not the Fed will again cut rates 50 points on Wednesday. Before the problems at SoGen were revealed, folks were looking for 50 basis points, and now, after the Fed got head-faked out of 75, people think we should get another 50, making a total of 125. I grant you, the economy is weak, but I didn't see anyone making the case two weeks ago that it was so weak that the Fed should cut 125 basis points (in sum: 75 + 50) -- which it's now expected to do.
To me, it just shows how completely in over his head Ben Bernanke is. Of course, the root cause of the problems we face is the interest-rate targeting championed by Greenspan and Bernanke. Only someone completely delusional would think that he knew how to pick the right interest rate to run a $14 trillion economy.
Paul Volcker achieved his greatest anti-inflationary success when he targeted the money supply. Money, admittedly, is not an easy target to define, let alone to hit. Some have suggested that the Fed just control the one thing it can indisputably control, namely, its own balance sheet. Let the Fed's footings expand by, say 3%, or 4% a year, and let interest rates go where they will. Greenspan and Bernanke fixed the funds rate and let credit growth go where it would. It went up.
The side benefit of a Fed targeting a somewhat quantifiable measure (like money supply) is that it lets the world know that interest rates are going to go where they're going to go, thereby reducing speculation. Thus, in addition to creating the misallocation of capital, the policy of targeting interest rates caused people to take far too much risk.
That's a quick and dirty explanation of the problems that are unwinding. Of course, they're far more severe than that, but regular Rap readers are well versed in the main problems in this country -- which stem from the fact that the average person can't afford his house and is now saddled with a debt that he's having trouble servicing.
Banks in the United States have been quietly borrowing "massive amounts" from the U.S. Federal Reserve in recent weeks, using a new measure the Fed introduced two months ago to help ease the credit crunch, according to a report on the web site of The Financial Times.
Regarding the Proliferation of Derivatives, I have in the past used a flood insurance analogy: If inexpensive and easily accessible flood insurance becomes available, this development will arouse a self-reinforcing building boom along the river. The newly offered insurance will increase individual risk-taking behavior and set in motion dynamics that pyramid systemic risk. Yet the insurance business will thrive, the riverside economy will boom, and it will appear to happy onlookers as a “miracle economy.” That is, until the inevitable flood arrives.
For the system, derivatives provide the means for altering, disguising and transferring risk, but not the mitigation of risk. And, unfortunately for systemic stability, this risk is too often transferred to speculators and highly leveraged players without the wherewithal to manage this risk in the event of a systemic crisis. Moreover, derivatives and structured finance nurture risk-taking. Specifically, they cultivate aggressive lending and leveraged speculation.
And a few comments are in order regarding the Government-sponsored Enterprises (GSEs). These are very problematic, unmanageable institutions at the very heart of today’s Bubbles. The GSEs enjoy unlimited access to Credit, thus operating with an extraordinary capacity to expand liabilities and create system liquidity. They are the major force fueling a historic Mortgage Finance Bubble, fostering destabilizing asset-inflation, over-consumption, endless trade deficits, and severe economic maladjustment. Moreover, they are the leading creators of system liquidity. This role becomes paramount during periods of systemic stress. I argue that they now operate as the key “Buyers of First and Last Resort” throughout the Credit market, essentially functioning as a Dual Central Bank. They have evolved into the Liquidity Backstop, emboldening the leveraged speculating community. This is an especially powerful and dangerous role for the GSEs. But, at the same time, they are the “Guardians of the American Dream.” Especially in today’s environment, the GSEs are politically invulnerable, and the debt market knows this.
And this transitions smoothly to the U.S. Bubble Economy. Recall the old adage “You are what you eat”? Well, I say “An Economy is How it Lends.” Financial Arbitrage Capitalism and its Dysfunctional Monetary Processes guarantee endemic unsound lending and the wholesale misallocation of resources. The character of liquidity now significantly impacts the nature of demand. The underlying structure of the economy is dictated by, and developed for, Credit-induced over-consumption, while the general economy has evolved to be asset inflation and services-centric. This ensures extreme investment and structural distortions.
The outcome is a lot of non-tangible “output” and “productivity,” along with an enormous inflation of financial claims. The problem is there is little in the way of true economic wealth to support this inflation. Therefore, today’s “monetary” economy is acutely vulnerable to any reduction in the growth of Credit.
Today’s Critical Issues:
The paramount issue is the intractable Credit Bubble – the antithesis of the stability offered by The Way We Were. The old banking system was relatively simple to govern, while today’s complex, expansive Credit system is virtually unmanageable. There are today three interrelated Bubbles. First, the Mortgage Finance Bubble. Second, the Leveraged Speculation Bubble throughout the Credit system. And third, the Risk Intermediation/“Structured Finance” Bubble
There is also the critical dilemma that we Can’t Even Turn These Bubbles Down, Let Alone Turn Them Off. Mortgage Finance is today the horse, while the economy is the cart. The Bubble throughout mortgage finance has become the overriding source for system liquidity and income growth.
Regarding GSE risk intermediation: The thinly-capitalized GSEs balloon exposure and use resulting boom-time experience to claim they will never suffer severe Credit losses. The GSEs have basically become the market, and the day they turn more cautious is the day the Bubble is in serious jeopardy. Unprecedented mortgage Credit growth has national prices levitated and many major localities in dangerous Bubbles. Any reduction in liquidity risks setting in motion a telecom-style bust.
Closely related is the issue of the Credit insurers. These thinly capitalized financial guarantors have written well over $1 trillion of insurance. But what would be the consequence - what impact on Credit Availability - if the insurers were to back away from writing new policies? I argue this is yet another Bubble; it only functions well during expansion.
All central banks are facing difficult choices in how to deal with the credit crunch. The European Central Bank is widely regarded as having responded effectively. But worries are growing that its success at easing liquidity constraints has come at the price of accepting low-quality assets, particularly mortgage-backed securities, as collateral.
Europe’s banks have pledged increasing amounts of asset-backed securities (ABS) as collateral against borrowing from the ECB. By the end of September, ABS represented 17 per cent, or €215bn, of €1,300bn total eurosystem collateral, up from 12 per cent in 2006 and zero in 2003. The Bank of Spain, one of the few national central banks to provide updated information in advance of the ECB itself next month, says net lending by the ECB to Spanish banks, much of it presumably ABS-collateralised, has increased from €18bn in August to €40bn in January.
The ECB itself points out that, compared to other central banks, it accepts a high volume of “private label” ABS, which are not government-guaranteed. The Fed has even looser eligibility criteria, but the BoE is stricter – although it did temporarily ease the rules in September and December. All three central banks apply a “haircut” to securities which subtracts a percentage of their market value according to maturity and type. And if collateral, which is revalued daily, no longer meets the eligibility criteria, borrowing banks must stump up an acceptable substitute. What happens, though, if other collateral is unavailable, is moot.
The ECB, to a certain extent, is a victim of its history and the need to amalgamate eligibility criteria from 17 national central banks. It is clearly aware of the dangers of its approach – in 2006 it tightened up the criteria for structured finance products, for example allowing only the most senior ABS tranches to be eligible. But the ECB is caught between a rock and a hard place – if it does not tighten the rules, it could face losses on low-quality collateral. But if it does, liquidity could well seize up again.
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