The fact that there is even a small liquidity crunch for banks implies larger liquidity crunches for less intensively regulated financial institutions, and even greater liquidity crunches for manufacturing and real-estate companies. It is hard to imagine that manufacturers are not now postponing orders of capitals goods, and that new home sales in the US are not dropping right now.
How does the Fed deal with such a situation?
Gingerly. A decade ago, former Fed chairman Alan Greenspan likened his problems of monetary management to driving a new car, having it suddenly stop, opening the hood, and not understanding a thing about what he saw. The changes in finance had been that great.
The Fed’s actions have involved what former Fed governor Larry Meyer calls “liquidity tools,” as opposed to interest rate-based monetary policy. The Fed hopes that it can handle the current situation without being forced to rescue market liquidity by cutting interest rates and thus giving what it fears would be an unhealthy boost to spending. The Fed still hopes that liquidity and confidence can be restored quickly, and that this summer will serve future economists as an example of how de-linked financial markets can be from the flows of spending and production in the real economy.
I think that the Fed is wrong: The fallout from the current liquidity panic means that a year from now we are likely to wish that the Fed had given a boost to spending this month.
DeLong has a bank-centric view of the world and seems not to have internalized how peripheral banks are as actors in credit intermediation these days. And because he is used to thinking in terms of traditional bank runs and liquidity crunches, he turns to traditional tools, namely, injecting liquidity.
Put it another way, this thinking is constrained by the familiar methods. If your only tool is a hammer, every problem looks like a nail. That ultimately may be the issue the Fed and other central bankers are up against.
DeLong and others treat the problem as liquidity, when the liquidity problems reflect concerns that Nouriel Roubini has discussed before, ones of insolvency and uncertainty. Lowering interest rates 50, or even 200 basis points is not going to make anyone any more willing to buy asset backed commercial paper. What might make them more willing is knowing if that particular counterparties have good collateral. Now I don’t know how you could create enough transparency to cope successfully with the fact that a lot of CP of all sorts matures this month, but a solution to that problem would considerably alleviate the seize up in the ABCP market, which is putting a strain on banks as ABCP issuers draw down on credit lines.
Similarly, cutting interest rates will not solve the problem of hung LBO financings, or subprime loans that are going to reset at higher rates, or commercial real estate financings done on overly aggressive terms, or hedge funds and pension funds sitting on CDOs and CLO traches that they know are worth less than they paid for them, but are hoping no one will re-rate it or otherwise take a step that would force them to discover a market price. John Dizard told us yesterday that some A rated paper that is yielding 35% on a current basis, is paying on a current basis and has good odds that the defaults won’t impair the principal value, is going begging. And he expects things to get worse.
I consider the problem analogous to the one described by Paul Krugman in his explanation in the New York Review of Books of why the Depression came about. Krugman disagrees with the common view that the Fed failed to provide enough liquidity:
If the money supply consisted solely of currency, it would be under the direct control of the government—or, more precisely, the Federal Reserve, a monetary agency that, like its counterpart “central banks” in many other countries, is institutionally somewhat separate from the government proper. The fact that the money supply also includes bank deposits makes reality more complicated. The central bank has direct control only over the “monetary base”—the sum of currency in circulation, the currency banks hold in their vaults, and the deposits banks hold at the Federal Reserve—but not the deposits people have made in banks. Under normal circumstances, however, the Federal Reserve’s direct control over the monetary base is enough to give it effective control of the overall money supply as well…..
In interpreting the origins of the Depression, the distinction between the monetary base (currency plus bank reserves), which the Fed controls directly, and the money supply (currency plus bank deposits) is crucial. The monetary base went up during the early years of the Great Depression, rising from an average of $6.05 billion in 1929 to an average of $7.02 billion in 1933. But the money supply fell sharply, from $26.6 billion to $19.9 billion. This divergence mainly reflected the fallout from the wave of bank failures in 1930–1931: as the public lost faith in banks, people began holding their wealth in cash rather than bank deposits, and those banks that survived began keeping large quantities of cash on hand rather than lending it out, to avert the danger of a bank run. The result was much less lending, and hence much less spending, than there would have been if the public had continued to deposit cash into banks, and banks had continued to lend deposits out to businesses. And since a collapse of spending was the proximate cause of the Depression, the sudden desire of both individuals and banks to hold more cash undoubtedly made the slump worse.
The difference between the Depression and now is that instead of having banks lend deposits as the main mechanism for financial intermediation, we have many other routes, particularly securitization and complete disintermediation of banks. Auto companies, for example, work with Wall Street to package and sell their car loans. ABCP conduits were another non-bank vehicle to obtain more efficient capital markets funding of mortgages.
This same point was made by Mohamed El-Erian, CEO of Harvard Management, in excellent article in the Financial Times, “In the new liquidity factories, buyers must still beware,” He explained that a great deal of the liquidity in the markets is created not by the monetary authorities, but by the participants themselves, and worked through a simple example, a private equity fund.
This is a useful piece, in that it provided an illustration anyone can use at a cocktail party, but has broad implications. The instruments and structures differ, but the process of creating ‘endogenous” liquidity is the same: borrow to buy assets, which when done on a large scale, leads asset prices to rise. We’ve pointed to other articles, most often in the FT, that describe liquidity creation on steroids, which results in risky borrowers getting overly favorable terms (subprime borrowers are far from alone).
El-Erian said, straight out, that the “leverage factories” have rendered the Fed’s 17 interest rate hikes ineffective. As he noted later, this makes a tough job even more difficult. Leverage cuts both ways. It amplifies gains and losses. All this leverage puts central bankers in an awkward position, for if they slow money supply growth, it could precipitate deleveraging, which would lower liquidity further than they had intended, which in an extreme case could lead to an economic slowdown or a financial panic. His scenario of late March is playing itself out now.
Now of course, the problem for DeLong, and ultimately Bernanke and other central bankers, is that if you accept that our current situation is serious (which a rate cut recommendation presupposes) but the likelihood of a rate cut achieving its intended aim is low, what do you do?
In short, as Roubini and James Hamilton have discussed, we may instead need a combination of fiscal stimulus and regulatory reform. That’s slow going, take a lot of thought, and requires the cooperation of Congress and the Admiinistration. So the appeal of resorting to interest rates (and praying they work) is obvious.