It’s always dangerous for mere mortals to take issue with Serious Economists, but let’s start with Brad DeLong’s thesis (hat tip Mark Thoma):
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.
I agree with you completely. Apparently BDL learned one thing doing economics – at the first sign of recession, have the consumer spend more and go into more debt. This works fine, as long as the consumer *can* assume more debt, which is pretty much the trend line of the last 50 years (which gives BDL the feeling that he is right empirically). But at some point there should be a limit, shouldn’t there?
DeLong has some good points. Add it to all the rest of the info sources on economics.
Plus, he also has this:
— former Deputy Assistant Secretary of the U.S. Treasury in the Clinton Administration
— research associate of the National Bureau of Economic Research
—- visiting scholar at the Federal Reserve Bank of San Francisco
Thanks for the Krugman link on uncle Miltie. As far as I’m concerned, Friedman was a corporate hack and there’s not a good word I can say about him except the world’s a better place since he died, as it is with Reagan gone. Maybe people in the US finally figure out that snake oil comes from “serious” people like these as well as Mr Andrea Mitchell. Then again, maybe not. They are after all, pretty amnesiac.
I forgot to mention that if it was up to me, I’d get rid of the Fed entirely.
I’m not saying that DeLong isn’t a well regarded economist. But he was assistant Treasury secretary under Clinton, which is when I imagine he developed his view of how finance and monetary management works, This would have put him there just as the changes in the role of markets were beginning to accelerate. And the Treasury supervises only banks.
The last credit crisis, the S&L-LBO bust period, were crises centered on the banking industry. The Treasury’s staff would also have had fresh memories of that period.
If you read the speeches of Timothy Geithner, President of the New York Fed, he essentially admits the Fed doesn’t understand the workings of our Brave New World of finance. The comment about not understanding what is under the hood by Greenspan is the same admission.
To extend the metaphor: why do you think putting more gas in the tank should work if what you have is no longer a car but a nuclear reactor?
El-Erian, BTW, is a professor of economics at Harvard, so he’s no mere trader but is also intellectually respectable. Roubini was a member of the Council of Economic Advisers. He is also a professor at Stern School, which (although it is a mere business school) is considered to be top notch in its finance faculty. But Roubini undermines himself by having an extreme, rather than measured, writing style. But his comments about insolvency and uncertainty have gotten widespread attention, and have been picked up by the Economist, the highly regarded Martin Wolf of the Financial Times, and other FT writers and guest contributors.
I am afraid that your comment regarding the misdiagnosis of subprime issues may be true of the liquidity issues.
First, on the contagion from big to small, financial to corporate, MacroMan has some charts on CP oustandings and pricing which show containment to, his phrase..”turds”
I think it is would be helpful to have commentators and policy makers who can distinguish between the various “crises” without creating a generalised drama. Blurring the picture appears to be the main interest of some.
The problem seems to be that no one knows exactly what the problem is yet, so everyone’s shooting at the side of the barn. And since that’s the case, no one can say with certainly what the solution is. That’s one reason Brad DeLong’s opinion is worth reading for me.
Nouriel’s been writing about this for awhile, well ahead of the pack that now is picking up on this recently because the numbers have finally gotten so bad they’re unavoidable. And as Brad Setzer is fond of saying, Nouriel can be quite blunt, but I like what he says because it makes sense and I don’t have to wonder what he meant when he says something. Big plus.
Remember the reverence everyone accorded Mr Know-it-all Greenspan, even though he was quite unintelligible when he spoke and Republicans held him in awe because he was “serious”. Bring back Volcker; at least when he said something, people knew what he was saying.
I’ll check into Timothy Geithner & El-Erian. Thanks.
Yes, no one really knows what the problem is but, in the most general sense, I believe we can say that there has been an ‘overproduction’ of debt, that this is global, and that it may well have reached maximium expansion as real economy limits have been coming into play.
slightly less generally, it stands out that ‘the’ problem is a complex of problems flowing from ignorance of where what risk is and how what is known should be priced. Years of risk displacement transformed into uncertainty that I doubt can be overcome other than through a generalized reduction of exposure.
yes, there’s a contradiction: how can exposure be reduced when the degree and extent are unknown, which is why I used the term ‘generalized’ (please recall that this does not mean smooth and even but combined and uneven).
In my opinion, Yves is exactly correct to bring out the fact that traditional banking has become secondary to a much larger, essentially unregulated, non-bank financial sector, and, from this, that central banks’ abilities to cotrol/mitigate have been very diminished.
“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.”
This chain of inferences does not seem valid to me. Cash on nonfinancial corporations’ balance sheet is really quite high at present. The liquidity issue is really limited to those who have short-term debt as a big part of their financing of long-term assets. That does not apply across all sectors.
Anon of 12:29 AM,
The quote you cited implies causality, that the problem starts with banks and gets amplified as banks cut/curtail credit to prospective borrowers. and you certainly read it that way too. But that isn’t the way this credit crunch is working.
The liquidity crisis is not taking place at banks. The immediate crisis is in the asset backed commercial paper market, which is about half the size of the CP market. Much of that paper cannot be rolled. Yes, there will be pressure on banks because many of the ABCP issuers have backup lines of credit and will draw on them. But the crisis is in full swing in the money markets and is roiling the US Treasury market as well. We aren’t yet seeing any serious impact at banks (the German bank failure, although dramatic, involved a very small player. The symbolism of the event, that a European bank was felled by US subprimes, was way out of proportion to the substance).
Similarly, there is a crisis of sorts in the leveraged buyout market. Investment banks made commitments to fund deals on terms that investors will no longer accept. The LBO firms are (so far) holding them to their agreements, which means they will have to increase the interest rate offered sufficiently to make the deal attractive. This means very large losses for the investment banks. Losses (and the general increase of volatility) will make them less willing to gear their existing capital bases (and big enough losses will reduce their capital).
The Bank of England listed 16 large complex financial institutions as effectively too big to fail. Were one to become seriously impaired, the BoE thought it could create a systemic event. The great majority of them aren’t banks (and in any event, the part the BoE was worried about was their securities operations).
In addition, the distress in the US housing market (and that is starting to appear in commercial real estate) is only indirectly caused by banks tightening their lending standards. They are doing so because they know mortgages, particularly subprime and Alt-A, will be more difficult to securitize than before and need richer coupons. Similarly investors have become much more stringent about commercial real estate paper. Highly leveraged players can no longer fund on terms competitive with buyers using more cash (this was not the case even a few months ago)
The housing bubble was fueled by investment banks letting banks know that their was high demand for mortgages at very attractive terms. That process has gone into reverse.
This is a long way of saying that a change in investor attitudes toward risk is driving this deleveraging. The impact on banks is a symptom, not a cause. And providing more liquidity will not, for example, create a sudden appetite for subprime paper or “cov lite” LBO financings.
And as we discussed, insolvency and uncertainty are two big contributors to the repricing of risk and the unwillingness of some investors to buy certain kinds of paper and assume counterparty risk. A cut in the Fed funds rate won’t solve those problems.
What of speculation that the overnight rates action may be an indicator of strong hands probing for weaknesses, and looking to shake out the rotten fruit rather than a generalised liquidity malaise?
Anon of 3:54 PM,
An interesting line of thinking.
I’m not on a trading desk, so I can’t say for certain, but my quick reaction is these markets are normally too deep and liquid for that to be a significant component of what is happening.
In an earlier post, I noted that Treasury trading was down by as much as 80%. That’s staggering. Similarly, the fall in CP outstanding has been large, and much more matures in September than did in August.
Those factoids suggest to me that trader brinksmanship is likely to be only a marginal factor.
So makes one wonder what are the options re: CP? Do liquidity providers have to raise cash? Do they raise other finance? How and where? For example NAB is taking 11bn onto their books, how have they gone about this?