Willem Buiter Heaps Scorn on Fed’s 75 Basis Point Rate Cut

Willem Buiter’s immediate reaction to the Fed’s emergency rate cut earlier this week was sharply negative, and upon reflection, his view has become even more critical. Buiter sees the reason for the cut as a “knee jerk” response to the prospect of a sharp fall in equity prices. He looks at the proximate causes of the fall – heightened worry about monoline downgrades, and the hasty unwinding of suddenly discovered trades at SocGen – and finds neither points to the sort of fundamental new information about the economy that might justify Fed action.

Note that the SocGen sales aren’t the first occasion in recent weeks that sales by a big player has helped fuel a market decline. Cassandra in Tokyo pointed to a sharp down day in Tokyo last week in which the pattern of trading suggested forced sales out of a major portfolio, and similarly, efforts to reduce quant pain played a role in market volatility in August. The Fed should have considered the possibility of exceptional, one-off factors before pulling the trigger.

By happenstance, Cassandra today has learned of the existence of the Bernanke Rule, which is a new and improved version of the Taylor Rule:

The Bernanke Rule, by contrast, stipulates how much the Central Bank should change the nominal interest in response to nominal divergences of the stock market indices from levels that cause those that own lots of stocks – whether leveraged or unleveraged – to hoot, howl, cry-foul, (and this is most important distinction) irrespective of what these changes in interest rates will do to the actual rates of inflation, inflationary expectations, in comparison to any reasonable target rates of inflation.

She and Buiter should compare notes.

Half the reason for reading the post is Buiter’s colorful phrase-making. For instance, he swiftly dispatches both the monoline business model and the adequacy (in dollar terms) of the rescue effort. He sees it as patently obvious that they are carrying far more risk than they can credibly handle. He is also, as we are, suspicious of the “rogue trader” explanation of the SocGen mess.

From Buiter:

Even with a few days worth of hindsight, the Fed’s out-of-sequence, out-of-hours 75 basis points cut in the target for the Federal Funds rate continues to look extraordinary and deeply misguided. Indeed, it looks less and less like a decisive pre-emptive move in response to unexpected bad news designed to meet the Fed’s triple mandate of maximum employment, stable prices and moderate long-term interest rates, than a knee-jerk panic reaction to a global stock market collapse.

Did the sharp global decline in stock values at the beginning of this week reflect a rational re-assessment of fundamentals? The only two candidate explanations I have heard are (a) that the collapse was probably triggered by concerns about the financial viability of the monolines and (b) that it was intensified by the unwinding by SocGen of the long equity positions taken by its employee of the year (not!). I find neither explanation convincing. If the collapse was a spurious, non-fundamental event, there is no reason for the Fed to react to it. The ability of the Fed to meet its fundamental objectives is seriously undermined if it is perceived as the poodle of the equity markets.


Fear about the credit ratings or even the financial viability of some of the monolines is not a plausible driver of a fundamentals-based stock market retreat. The monolines insure default risk. They don’t diminish it, but only spread it. They therefore fulfil the same economic function as credit default swaps (CDS).

When a monoline insures credit risk, this has a number of consequences. First, if no default has occurred as yet, the debt instrument (a bond, say) that is insured now carries a lower risk premium, provided the probability of default of the monoline is lower than that of the original issuer of the bond and provided the default risk of the original issuer and of the monoline are not perfectly correlated. This is one reason why monolines without a AAA rating cannot get new business. Second, the original issuer (or the party offering the credit-risk-insurance-enhanced instrument) pays an insurance premium to the monoline. If markets are reasonably efficient, there should be no free lunch here: the cost of the default insurance should equal the reduction in borrowing costs permitted because of the insurance.

Third, when a default occurs, it redistributes the financial cost of the default from the holder of the debt instrument to the monoline.

Finally, if monolines are better able to bear the default risk than the issuers of the securities they insure, and if other credit risk insurance mechanisms (e.g. CDS) are not perfect substitutes, there will be an increase in economy-wide efficiency. This could, but need not, be reflected in an increase in aggregate stock market values (adding together the equity of the issuers of the debt and that of the monolines).

Monolines are few in number and small. They don’t have a lot of capital. It seems unlikely that, in an even vaguely rational world, their existence would make a huge different to the performance of the credit markets and, indirectly, the equity markets. It is clear that, while they may well offer credible protection against idiosyncratic default risk of individual borrowers, they will offer no protection against a significant economy-wide increase in defaults, such as may be associated with a recession. Monolines are unbelievably leveraged: last year the value of their outstanding guarantees was 150 times capital, with the notional value of the insured assets at around $ 3.3 trillion and capital of between $20 billion and $25 bn.

It does not take a wildly implausible increase in the level of the average default rate to wipe out this capital. I don’t understand a business model for default risk insurance which implies that your capital will be wiped out if less than 0.7 percent of your insured assets go belly-up. The efforts by New York state’s Insurance Superintendent to get a posse of banks to put up between $ 5.0 bn and $15.0 billion to shore up the capital of the monolines, after one of the largest two (AMBAC) lost its AAA rating, seem modest compared to reasonable estimates of the expected losses of the monoline industry. Perhaps the decimal point should be moved one place to the right?

In addition, the monolines share a feature with one of the other villains of the securitisation crisis: the rating agencies. The rating agencies started out rating sovereign debt and large corporates – an activity that does not require more than an abacus and a modal IQ. They then expanded into the rating of complex structured products (ABS, CDOs etc.). They were revealed to be out of their depth in this business.

The monolines started life in the 1970s as insurers of American municipal bonds. In recent years, they have expanded on a large scale into the insurance of complex structured products, such as ABS and CDOs. While there appears to have been little exposure of the monolines to thesubprime market, it would seem to this outsider that they either grossly underestimated the default risk on the bonds they insured, or grossly underpriced it. (They were of course not alone in this during the years of global underestimation/underpricing of credit risk and all other forms of risk from 2003 till 2007). With the reassessment and repricing of risk now under way, it is inevitable that the monolines would take a massive hit and that new underwriting business would be on much more stringent terms. The entry of new, and one hopes better capitalized, firms, such as the venture created by Berkshire Hathaway, into the monoline industry is therefore very welcome.

But the magnitude of the stock market declines stands in no proportion to the fundamental importance of the monolines, even in aggregate. With their ludicrously high leverage, they were never able to provide any kind of cushion against even a small increase in aggregate as opposed to idiosyncratic, default risk.

Société Générale

The fraud at Société Générale, resulting in a € 5bn loss will provide bloggers and columnists everywhere with material for weeks to come. It raises serious issues for regulators and supervisors of banks and other financial institutions. But it is not a macroeconomically significant event. Like all theft, the fraud itself merely redistributed wealth, without any obvious effects on aggregate demand. To make a loss of €5bn, there probably was an exposure of between €50 and €70bn. Société Générale closed all these positions in a hurry starting Monday. This may have contributed to the stock market decline in Europe, but the rout was already under way in Europe (and earlier in Asia), before Société Générale did its bit for the bears. I assume the Fed must have been informed of the Société Générale debacle by the French regulator (the Banque de France) before it decided on its rate cut (Monday evening US time).

The stock market sometimes loses its nerve. Left to its own devices, it will recover it. There is no monetary policy mandate to protect those who lose their nerve against those who don’t. So it looks as though the Fed, like the stock market, simply lost its nerve.

As an aside, I am usually a believer in the screw-up theory of history rather than the conspiracy theory of history, but in the case of Société Générale I am not so sure. How could one man, a junior trader, even if he is a wizz at Solitaire, carry a € 50 billion to € 70 billion position day after day without anyone else noticing? He is supposed to have been long equity. That cannot have been a long outright position, because this would have been noticed in the cash markets. It cannot have been in the equity futures markets either, because that requires margin payments whenever stocks fall. The perp would have been caught a long time ago. So how did he do it? Did he sell equity puts? Could he have done this on his own? Unlikely, I would say. He has also, conveniently, disappeared. If he is found hanging from a bridge somewhere, my suspicions that there is more to this than has thus far met the eye will have been confirmed.


The stock market giveth – the stock market taketh away; and then the stock market giveth again etc. Most of the high frequency movement in stock prices is fluff – noise that policy makers ought to ignore.

Many commentators talk as if a recession in the US is a done deal, with a recession in the UK not far behind and significant weakening in Euroland coming up fast in the outside lane. I am not so sure.

A recession in the US is possible, but not in my view the most likely outcome. Employment appears to be holding up better than would be consistent with the economy already being in recession or about to enter it. Clearly, the housing sector and the financial sector in the US have over-expanded in the latest credit boom and will have to contract painfully. Profits, capital and employment in these two sectors will all fall. But outside these two sectors there has not been any significant degree of excessive capital formation in the US economy. The same holds for the UK. In Euroland the situation is even better, because there the housing sector has only expanded excessively in a few cases (Spain and Ireland), while the financial sector appears to have expanded excessively only in the Netherlands, Germany, Spain and Ireland.

The contraction of the financial sector will have repercussions for the non-financial economy, especially for the household sector, which is more highly leveraged than the non-financial corporate sector. But as yet there is no sign of a major across-the-board decline in activity even in the US, let alone in the UK and in Euroland.

Both the housing sector and the financial sector are among the most vocal sectors in the economy. The amount of attention paid to these sectors by politicians, policy makers and the media is quite disproportionate, when compared to their fundamental economic significance. When regulatory capture extends to the central bank, the quality of monetary policy making is bound to suffer. We have seen this in the US since Greenspan took over from Volcker as Chairman of the Fed. And it continues today.

We will see a slowdown in global growth, with the most severe slowdown likely in the US and the UK. But even there I don’t understand how those yielding the R-word can be as confident as they pretend to be.

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  1. john c. halasz

    Um…leveraged “household sector”. Doesn’t that mean consumers and workers? If the non-financial corporate sector is underleveraged that’s because they’ve seen no reason to invest, and if consumer demand together with consumer credit contracts, what further reason would they have to invest? In fact, with declining demand and excess capacity, wouldn’t the valuation of current investments begin to deteriorate?

  2. doc holiday

    As the stock market drifted lower today, I had hopes of another rate cut! I wonder if bonds go up more, if that will have an inverse relationship related to something? The S&P 500 is still at least 5% overvalued, so I wonder how many rate cuts that equals? I think maybe 3 cuts, and as you recall Ben did suggest many months ago that we would hear from The Fed on a more regular basis; no kidding!

  3. Yves Smith

    john c. halasz,

    I am with you on the outlook. Businesses have shown high profits by clamping down on expenditures of all kinds. That has led to them shunning investments (investments lead to increased costs as well as requiring a capital outlay). They have become neurotically fixated on short-term bottom line, thanks to Wall Street.

    The lack of investment says to me that the earnings growth has been due in large measure to cost cutting. That means companies have really been disinvesting. That will catch up with them eventually, independent of the macro outlook.

    And Buiter misses the leverage story. Public companies don’t have too much debt, but the average rating is just a hair above junk due to all the highly geared big LBOs.

  4. David

    Seems to me like a recession is a given:

    Consumer consumption is >70% of the economy. Much of that consumption has been by means of credit. Banks are now severely tightening consumer credit of all kinds, and will continue to do over the next several years. The only potential upside is manufacturing (iff the $ keeps tanking), and I don’t see us bringing that kind of additional capacity online until long after the credit monster has eaten our lunch.

    I think your writing is very good, and dead-on for the most part. Suffice it to say, my jaw hit the floor at your sunny outlook. I hope you’re right, but I don’t see how you can be.

  5. Anonymous

    re: Sunny outlook

    Dr Roubini has suggested that the pessimism may be at or near it most climactic. He long ago earned my maximum respect for gutsy consistent call and not fluttering like a weatherwane with the vicissitudes of the market – to deliver a near-perfect foretelling of the chain of events that would lead us to where we sit today. Bravo. He was, of course a year early, which is a dogs-life in markets. And before anyone punch the “buy-basket-button” on their Portfolio Trading software, reminisce for a moment about the number of snuffed rallies, aborted bulls, and near-suicidal swoons between the 1991 lows in Japan, and the ultimate lows more-than-a-decade later in 2002. The sheer number of Fiscal Stimulus packages, end-of-bear calls, and bullish headfakes are worthy of some careful study for those believing that it is within the authorities power to legislate away the unwinding of a decade-long binge which has fundamentally changed the nature of the American economy…and not for the better.

    Japan never felt like a depression, and rarely felt as if it were in deep recession, whilst relatively, in real terms it gave up 30%. Maybe their society’s idiosyncratic social structure needed a decade of adjustment to maintain peace and order. But can you imagine the outcome of another decade in the USA of increasing inequality, declining real wages for a large share of the people, even if unemployment or inflation ever reaches 70s levels??

    I’ve no answers, only questions, though I’ve always preferred to pull the band-aid quickly and painfully off of a wound, rather suffer a more-drawn-out but only slightly-less excruciating pain. It may not, in actual fact be better for the wound, but psychologically, I reckon its better to hit bottom faster and deeper, for almost everything thereafter can be seen as improvement, and THAT I believe, does wonders for optimism, investment and the Public Inerest as a whole.


  6. Yves Smith


    As someone who is now considerably removed from Japan, I am glad to hear you confirm my impression, that the horrors of the lost decade are overstated. The Japanese had a simply massive overhang after the bubble years. I don’t see how they could have avoided socializing at least some of the losses.

    I have also wondered whether the wreckage is more a money than a real economy phenomenon (at least in recent years). What if the deflation is worse than the authorities say, perhaps -2%? The two drivers for growth are demographic growth and productivity gains. Japan has horrific demographics, but what if the zero nominal growth means 2ish% real growth due to deflation? I hate to sound dense, but I don’t know of any economist (at least one published in the West) who has worked through a scenario like that. Everyone halts at “Oh, deflation is terrible, you’ve just emasculated the monetary authorities.”

    Your point about it not feeling like a depression: you are right, we won’t have such a benign outcome here. First, the overleverage was in the corporate/commercial real estate sector. Companies were borrowing 100% against inflated real estate values. So individuals weren’t directly exposed, while here, the leverage has been in the consumer sector. And Japan as a matter of policy gave priority to preserving employment and keeping the income distribution from getting too skewed. Here it is devil take the hindmost.

  7. john c. halasz

    Yves Smith:

    Just to follow up, from a purely U.S.-centric perspective, if non-financial profits have been high, that, in the first place, is because of astonishingly low interest rates, which allowed for the replacement of accumulated debt at much lower cost, and, of course, lowered the cost of any new investment. However, low interest rates didn’t stimulate any remarkable increase in cap-ex, ex construction, which has been low to mediocre this cycle, because, on the one hand, wage stagnation has led to soft demand conditions, ex MEW, such that cost cutting has been the only way to maintain profits, absent market pricing-power, which means off-shoring, not just for large MNCs, with long-range strategic planning and operating capabilities, but for a lot of smaller firms needing to compete in such an environment. Hence, though profits are high as % of GDP, cap-ex is low as % of GDP, and the vacuum is filled by debt-financed PCE as % of GDP. And insofar as profits have not simply been returned through the likes of stock buy-backs, I’d guess they’ve been parked for “high” financial returns. There simply hasn’t been enough domestic demand to warrant cap-ex expenditures, even though the interest cost has been low, especialy in the aftermath of IT overinvestment, and what investment is warranted can be better accomodated overseas.

    As for LBOs, there’s an inherent contradiction at work. Either equity markets are notably inefficient, so as to tolerate poorly performing company managements, who under-utilize and misallocate capital stocks, so that taking a company private allows for long-range reinvestment, which inhances productive performance, which promises long-range equity returns,- in which case the “efficient markets hypothesis” is wrong and the financial system superintending capital allocations is seriously deficient; or they are a product of an over-financialized approach to productive business, in which a combination of cash-rich businesses, low interest rates (and easy credit liquidity), and lagging equity “values”, (which, measured in terms of inflation and the trade-adjusted $, have never returned to prior levels, even nearly, and that with the stock buy-back and LBO craze), resulting in temporarily attractive deals, based on current financial accounting, without consideration for longer-range effects. Needless to say, given my cynical, outsider status, I tend toward the latter hypothesis: namely, that LBOs mostly amount to a form of rent-seeking based on the stripping of “intangible assets” and “business goodwill” from business organizations. This is based upon my uninformed hunch that real productive businesses in the real economy, especially when there is large, relatively long-term, and illiquid real capital investment involved, require sector-specific know-hows to manage their capital stocks and organization under variable market and macro-economic conditions, which is not the sort of thing that is obvious from reading quarterly financial statements, even in terms of sector specific comparisons, (since one company might be up and another down in any given period, but each is intensely aware of its market and its competition). An easy example of the destruction of “goodwill” would be Circuit City’s firing of its experienced sales staff to cut costs early last year. But that sort of ham-fisted decision-making might be multiplied in any number of ways across any number of business sectors. Even aside from rising interest rate spreads and tightening credit standards, I suspect that’s precisely the sort of thing that might doom the long-run results of LBO deals. The only question is whether the legal structures have been deft enough for the head honchos to escape the consequences.

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