Wolfgang Munchau Argues Against Over-reliance on Monetary Policy to Stem Subprime Crisis

A good comment in the Financial Times by Wolfang Munchau on the merits of the various remedies available to address the credit crunch. He argues that for monetary policy to be effective would require deep interest rate cuts (200-300 basis points), risking inflation and still leaving quite a few stressed borrowers no better off. He instead favors greater use of regulatory reform and targeted fiscal measures.

From the Financial Times:

The subprime crisis is a massive macroeconomic shock in need of a determined policy response. But what kind? It will probably not require a symmetrical response across countries and policy instruments but a more targeted strategy.

The US and the UK, for example, should respond harder than the eurozone and Asia, where the recession probability is much lower. While I never believed in decoupling – the theory spun by exuberant investment bankers that the rest of the world could happily grow when the US was in recession – this is an asymmetric crisis nevertheless.

If you live in a credit-addicted, English-speaking country with a large financial centre, you are more likely to be in trouble.

Nor should central banks, regulators and fiscal authorities open all the policy valves at the same time. The correct response is to use fiscal and regulatory policy aggressively – and monetary policy judiciously. In fact, there was some evidence last week that we are moving in that direction.

The European Central Bank was right in signalling a possible rise in interest rates next year, given prevailing inflationary pressures there. The US Treasury was also right when it came up with a scheme to bail out distressed subprime borrowers by freezing interest payments.

The only fault I could find with the US scheme is that it may not be sufficient – that the US government needs to do more to help mitigate the spillover from housing to the real economy.

The scheme, as it stands now, will not do anything to prevent a sharp economic downturn – but it might just help prevent a downturn becoming a depression. But even in the US, where there is a risk of an outright recession, a monetary over-reaction would be a serious mistake.

One reason is that monetary policy may not be as effective as regulatory and fiscal policy. For monetary policy to be able to bail out distressed borrowers would take cuts in interest rates of the order of some 200 to 300 basis points. And that would only work for those borrowers that can refinance immediately.

It is far better to bail out the distressed mortgage holders directly, if necessary through subsidies. The US has led the way, and Germany and Italy are also discussing relief plans.

Another important reason is the rise in global inflation. This is why Japan’s descent into deflation in the early 1990s offers fewer lessons than some people may think.

While it is true that in the past central banks often made the mistake of under-reacting, rather than over-reacting, this is not a generic lesson of financial crises. The early 1990s was a period of global disinflation. The Japanese asset price crash resulted in deflation and policymakers were in denial at the time.

That is surely not the case now. Global inflation is rising. Globalisation has entered a phase where it no longer just supplies us with cheap goods, but in addition creates large and rising demand for resources with supply constraints, such as oil, food and logistics. Another reason is that the period of wage deflation in western economies may also be coming to an end.

If we are unlucky, we might even end up with stagflation. If, as some commentators have urged, we use monetary policy too aggressively, we risk turning a credit squeeze into a wider financial crisis.

Higher inflation would, of course, help ease the immediate credit crisis as it shifts wealth from lenders to creditors. But it would bring on another, probably much bigger, crisis as investors would then start to desert the US bond market.

The last thing the world economy needs right now is a global bond market crash and an ensuing rise in real interest rates.

Central banks are therefore best advised to focus narrowly on price stability. Of course, a central bank also has responsibility to ensure financial stability, but this should not be confused with bailing out insolvent banks. In fact, it would probably be very healthy for the global financial system if some of those reckless mortgage lenders were allowed to go bankrupt.

A central bank’s role should be confined to providing ample liquidity to the markets through its regular money market operations. This is not at all in conflict with its price stability objective. Why should a central bank not be able to raise interest rates and increase its liquidity provisions at the same time? These two instruments serve different purposes.

Nor is an inflation-targeting approach at a time like this necessarily bad for economic growth.

A pure price stability strategy, if applied persistently and symmetrically, surely offers insurance against deflation and depression, just as it offers insurance against inflation and overheating. If inflationary expectations were to fall below the target, the central bank would still have plenty of time to act vigorously to bring expectations back in line with the target.

It is difficult to make the case at this point that the Federal Reserve is in any danger of undershooting its inflation target.

So if the Fed were to cut interest rates this week, it would be sending out the message that it is ready to let inflationary expectations rise. Even if the Fed goes down that road, the Europeans should walk the other way. I am now more optimistic than before that they will.

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  1. a

    Housing prices are too high with respect to income. There’s no magic wand which can correct that, and analysts pretending that the government can do something to make a softer lander, are part of the problem.

    What the government can do is create a better regulatory structure so that future crises are less likely to occur.

  2. doc holiday


    Picking up from last night, check this out from one of my SEC snips, as it related to The Fed allowing commercial paer to be used as collateral (renting cash and cash eqivalents for the balance sheet):

    A majority of our subsidiaries rely on exceptions and exemptions from the Investment Company Act. These exceptions and exemptions limit the types of assets these subsidiaries may purchase. For instance, CDO I and CDO II rely on the exemption from the Investment Company Act provided by Rule 3a-7 thereunder, which is available for certain structured financing vehicles. This exemption limits the ability of these CDOs to sell their assets and reinvest the proceeds from asset sales. Our subsidiary that invests in net lease properties and certain other subsidiaries rely on the exception from the definition of “investment company” provided by Sections 3(c)(5)(C) and possibly Section 3(c)(6) and of the Investment Company Act, which except companies that primarily invest in real estate, mortgages and certain other qualifying real estate assets. These exceptions limit the ability of these entities to invest in many types of real estate related assets and their holding companies. We believe that we are not an investment company because we satisfy the 40% test of Section 3(a)(1)(C). We must monitor our holdings to ensure that the value of our investment securities do not exceed 40% of our respective total assets (exclusive of government securities and cash items) on an unconsolidated basis. Our subsidiaries that engage in operating businesses, if any, are not limited by the Investment Company Act.

    >>> Note the language of how a CDO as an off balance sheet entity is NOT an investment company;

    40% test of Section 3(a)(1)(C

    >> There was a story, where I think someone focused on this swap for cash in terms of JPM or one of the big banks using the discount window as a way to conceal reporting mark-to-markit…..

  3. doc holiday


    These are intended to “add or drain reserves available to the banking system”. The amount “accepted” each day is the amount of reserves added that day. But, these being temporary operations, they mature in 1-14 days at which point the banks have to return the cash. On a given day, there’s a certain amount that has been added to the system that has not yet matured (doesn’t have to be returned yet). These amounts are said to be “sloshing” in this report.

    Is sloshing good ol fashioned window dressing?

  4. doc holiday

    These were the issues the Fed tried to tackle with the temporary changes announced Friday. The rate was cut to 5.75% from 6.25%, just half instead of the usual full percentage point above the funds rate. The term of discount loans was extended to as much as 30 days, renewable by the borrower, from the usual one day. These terms were meant to make discount loans a more viable alternative to fed funds. Federal Reserve banks also can accept a wide range of collateral for discount loans, such as subprime mortgages as long as they’re not impaired, and triple-A rated “private-label” mortgage backed securities. (These terms did not change yesterday.) That’s one advantage the discount window has over the Fed’s open market operations, in which only Treasurys, bonds issued or MBS guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are acceptable.

    And in an effort to eradicate the stigma, Fed officials convened a conference call of major Wall Street institutions to announce that “appropriate” use of the discount window would be seen as a “sign of strength.” The Fed is trying to overcome the “collective action problem,” i.e. the refusal by one bank to act unless all its competitors do the same. Normally the collective action problem applies to a reluctance to take prudential measures, like insisting hedge fund customers supply more collateral, but it also applies to activities with a stigma, like discount window borrowing.

    Because major investment banks such as Morgan Stanley, Goldman Sachs and Merrill Lynch were included in Friday’s call there was speculation the Fed was trying to open the discount window to them. Fed officials emphasize the discount window is only available to depositories (banks, thrifts, credit unions and “industrial loan companies” or ILCs). Depositories are allowed access to the federal safety net of the discount window and deposit insurance only because they also submit to a panoply of federal oversight, including capital requirements and close supervision.

    Some investment banks are part of bank holding companies like Citigroup and J.P. Morgan Chase with large bank units . Some investment banks own depositories, primarily ILCs. But these units are small and lack the capital needed for a significant expansion of lending. Moreover, the Fed and other bank regulators have traditionally been careful not to let banks that are part of larger companies become sources of funds for riskier activities by their affiliates. Some finance companies such as Countrywide Financial that control depositories could use the discount window to finance mortgages that can’t be securitized in current market conditions.


    August 18, 2007, 12:20 am
    More on the Fed’s Discount Window Action

  5. doc holiday

    Hello, is there anybody out there, just nod if you can hear me……..

    The term of discount loans was extended to as much as 30 days, renewable by the borrower, from the usual one day. These terms were meant to make discount loans a more viable alternative to fed funds. Federal Reserve banks also can accept a wide range of collateral for discount loans, such as subprime mortgages as long as they’re not impaired, and triple-A rated “private-label” mortgage backed securities. (These terms did not change yesterday.) That’s one advantage the discount window has over the Fed’s open market operations, in which only Treasurys, bonds issued or MBS guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are acceptable.

  6. doc holiday

    Federal Reserve banks also can accept a wide range of collateral for discount loans, such as subprime mortgages as long as they’re not impaired,

    That means someone would have to recognize a loss, and that whats keeping this game afloat, as they window dress reality!

    Im not saying bank failures should happen, its great The Fed is trying to bail out bad casino bets, but Jonny gonna come back fo more crack if someone doesnt start doing some kinda regulation to prevent bogus FASB, GAAP and SEC adjustments to this fraud! Its a total sham and dont get me started on the linkage to The Pension Reform Act, which is allow pension cash to be swapped like casino chips!

  7. doc holiday

    This is a great end to this postathon:

    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.

  8. doc holiday

    Dear Senator Boxer,

    First, thank you for your vote, last year!

    Re: http://www.senate.gov/legislative/LIS/roll_call_lists/roll_call_vote_cfm.cfm?congress=109&session=2&vote=00230

    U.S. Senate Roll Call Votes 109th Congress – 2nd Session

    as compiled through Senate LIS by the Senate Bill Clerk under the direction of the Secretary of the Senate

    Vote Summary :

    YEAs 93

    NAYs —5
    Boxer (D-CA)
    Burr (R-NC)
    Coburn (R-OK)
    Cornyn (R-TX)
    Feingold (D-WI)

    Not Voting – 2
    Baucus (D-MT)
    Lieberman (D-CT)

    Re: President Bush Signs Pension Reform Act; Cross Trading Exemption Included
    President Bush this week signed the Pension Reform Act (H.R. 4), comprehensive pension legislation that represents a significant overhaul of the prohibited transaction provisions of the 32-year old Employee Retirement Security Income Act. H.R.4 is Public Law No: 109-280. The changes include a prohibited transaction exemption for cross-trading between separate pension accounts held with the same money manager and boost the level of ERISA assets that can be invested in investment vehicles such as hedge funds. Under the legislation, cross-trading would be allowed for private pension plans with at least $100M in assets, resulting in lower transaction costs for pension plans.

    November 30, 2007 6:27 PM

    Re: August 2006 – Landmark pension reform legislation passed last night by Congressand expected to be signed by the President this month includes the most significant changes to the fiduciary provisions of ERISA since its enactment in 1974. The new legislation (the “Pension Reform Act”) significantly relaxes the rulesgoverning when asset-backed securities (“ABS”), including commercial mortgage backed securities (“CMBS”) and collateralized debt obligations(“CDOs”), may be offered to investors holding certain types of retirement planassets. Absent an exception, issuers of ABS, CMBS and CDOs that are not structured as debt must comply with ERISA, including its stringent fiduciary and prohibited transaction rules — which is not practical for most ABS, CMBS and CDO issuers. One regulatory exception (known as the “SignificantParticipation Exception”) relied on by many issuers of either below-investmentgrade ABS, CMBS and CDOs or ABS, CMBS or CDOs that are notcharacterized as debt for tax (each of which typically cannot be characterized asdebt for ERISA purposes) applies if an issuer does not have “significant participation” by “benefit plan investors”.

  9. doc holiday

    I just have to add:

    Re: Vote Summary :

    YEAs 93

    NAYs —5
    Boxer (D-CA)
    Burr (R-NC)
    Coburn (R-OK)
    Cornyn (R-TX)
    Feingold (D-WI)

    Not Voting – 2
    Baucus (D-MT)
    Lieberman (D-CT)

    I dont see Hillary or Obama on the side of the little guy that has a pension, who wants it safe, risk free and out of the hands of hedge funds…..thanks guys, hope one of you wins next year, so you can help our country be free and strong………you retards!

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