How the US money market really works
By Henry C K Liu

http://www.atimes.com/atimes/Global_Economy/GJ27Dj01.html

And the rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines. In the US, the central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed funds rate, which its Open Market Committee tries to match by lending or borrowing in the money market. Thus fundamentally, the money market is not a free market, but one dictated by the central bank with a particular preference for the resultant state of the economy. The so-called free-market capitalism operates through this command money market. Thus at the heart of the free-market ideology is a fiat money system set by command of the central bank. The Fed is the head of the central-bank snake because the US dollar is the key reserve currency for international trade. The global money market is a US dollar market. All other currencies markets revolve around the US dollar market.

When a government’s Treasury issues sovereign debt, the money proceeds go to finance the portion of the fiscal budget not covered by taxes. When government runs a fiscal deficit, it takes money from the private sector by issuing sovereign debt and spends the money back in the private sector. Thus the important issue is not if the government runs a fiscal deficit, but how the fiscal deficit is spent. A fiscal deficit does not reduce the total money supply; it only increases the amount of debt. But monetary economists such as Hyman Minsky assert that whenever credit is issued, money is created. Thus the issuing of government bonds is the government’s way of issuing money without the involvement of the central bank. This is why Federal Reserve Board chairman Alan Greenspan is always warning about the fiscal deficit.

Yet the notion that government borrowing crowds out private borrowing is controversial. Fiscal deficits do not even directly affect short-term interest rates, which are set by the central bank. If the government wishes, it can take money directly from the central bank, which is legislatively authorized to issue money by fiat as the sole legal tender in the nation. A country’s fiat money enjoys currency because the government accepts it for payment of taxes.

Fiat money is in fact a form of tax credit, or sovereign credit. Sovereign debt instruments do have a market function: they provide the assets that a central bank can buy or sell in the repo market to meet its Fed funds rate targets.

Bonus material>>>>>>>

Hence investors in credit-linked obligations (CLOs) are exposed not only to inherent credit risk of the reference portfolio but also to operational risk of the issuer. Systemic stability cannot be enhanced when the system is decapitated, as exemplified by the 1998 collapse of Long Term Capital Management (LTCM), which required Fed intervention to prevent systemic instability. With world financial markets already suffering from heightened risk aversion and illiquidity from the 1997 Asian financial crisis, officials of the Federal Reserve Bank of New York judged that the precipitous unwinding of LTCM’s portfolio that would follow the firm’s default would significantly add to market problems, would distort market prices, and could impose large losses, not just on LTCM’s creditors and counterparties, but also on other market participants not directly involved with LTCM. In an effort to avoid these difficulties, the Federal Reserve Bank of New York (FRBNY) intervened with the major creditors and counterparties of LTCM to seek an alternative to forcing LTCM into bankruptcy. The hedge-fund industry has since grown with an increased number of funds, which will make the dispersed risk crisis more complex for future Fed intervention by virtue of the large number of interested parties that need to be satisfied.

Greenspan acknowledged that derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an oversized Achilles’ heel. It appeared that the benefit had been reaped in the past decade, leading to a wishful declaration of the end of the business cycle. Now we are faced with the oversized Achilles’ heel, with “the possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked”. According to Greenspan, “only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence central banks have, of necessity, been drawn into becoming lenders of last resort.”

Greenspan asserted that such “catastrophic financial insurance coverage” by the central bank should be reserved for only the rarest of occasions to avoid moral hazard. He observed correctly that in competitive financial markets, the greater the leverage, the higher must be the rate of return on the invested capital before adjustment for higher risk. Yet there is no evidence that higher risk in financial manipulation leads to higher return for investment in the real economy, as recent defaults by Enron, Global Crossing, WorldCom, Tyco and Conseco have shown. Higher risks in finance engineering merely provide higher returns from speculation temporarily, until the day of reckoning, at which point the high returns can suddenly turn in equally high losses.

It’s so cute when the defenders of power, privilege and the status quo try to make themselves over as dissidents. In general, I think, they actually believe it. But why wouldn’t they?

But excuse me. I need to go to my economic-royalist meetup. Plus my crown needs letting out again, and I’ve got some peasants to thrash. I’m telling you, it’s not easy being “orthodox.”

Are we questioning the deregulation orthodoxy?

My dears, we must remember: regulation everywhere and at all times is always The Problem. The Federal government should be reduced in size until it can be drowned in a bathtub. Grover Norquist said that and he must be right because he’s a leading Republican, and we all know they are the Grownups in the political sphere.

Myself, I think there is only one function of government: to investigate the marital lives of all public ’servants’ and if they are not properly monogamous according to Christian principles, Impeach em!

Will cosmetic surgeons.. ski resorts and purveyors of fine stuff keep the Xmas spirit alive?

Abracadabra

In future, when you need a loan, you’ll just apply to the government. The State will bundle your loan with other similar securities, guarantee it, and sell it. When lending policies are standardized by regulators, all loans are securitized, and the market for loans is protected by the Greenspan put, we have basically reached this point already.

You have already done the math. In an open-loop financial system with systematic mismatched maturities, banks are and always will be wards of the state.

In fact, it seems a sensible step to exchange their present names, such as “Citigroup,” “Bank of America,” and so on, for a numbering system ordered by present market cap. So we could call them People’s Bank #1, People’s Bank #2, etc, etc.

In case this strikes you as a little creepy, however, Austrian economics is only a click away.

http://money.cnn.com/2007/11/27/news/newsmakers/gross_banking.fortune/index.htm?postversion=2007112810

The rest is speculation. It isn’t clear yet how well the industry’s capital will stand up to this round of losses until the ultimate losses are known, which will be some time yet.