Readers have taken to throwing brickbats when I post material that suggests that raising interest rates (at least in advanced economies) might not be a good move right now.
We’ve said before that the reason the Fed kept rates too low too long was it looked at inflation as strictly a domestic phenomenon and ignored the inflation-suppressing effects of cheap imports. That process has gone into reverse due to high oil prices and rising import prices. Remember, the reason high interest rates kill inflation is by slowing economic activity. That’s already happening, and I am highly confident things will get worse all by themselves if the Fed and ECB merely stand pat.
The problem is inflation in emerging economies, particularly China. The Chinese stock market (not a perfect indicator, to be sure) says growth is slowing big time. We noted in a post yesterday that there are other indicators, such as significant factory closings, that say Chinese growth may be about to downgear fast. We’ve noted in passing, and reader Independent Accountant noted longer form, that an increase in fuel prices is having the same effect as tariffs. Hello, Smoot Hawley?
And as painful as high oil prices are, if you believe they are the result of supply and demand, a runup this fast is producing considerable demand destruction. We’ve seen it already in the US based on April results, and oil was only $110 to $120 a barrel then. The effect of cuts in fuel subsidies in China and India have only started to work their way through the economy. The blunt instrument of monetary policy is not the answer to high fuel prices.
Note we are not applauding Bernanke’s moves to date. We think he cut too deeply, too quickly, and left the Fed with no maneuvering room. It would be better if the Fed funds rate were, say, 100 basis points higher. But increasing it to that level would wreak so much havoc on banks that you’d get (in the end) such massive fiscal stimulus that it could more than undo whatever benefit there might be via a modest rate increase.
Yes, negative real interest rates normally lead to speculative investment. But pray tell who is getting credit in the US now? Consumers most certainly aren’t, businesses have it tough, the mortgage market depends on Federal guarantees, and by all accounts, the credit markets are having liquidity issues in many sectors. We saw a different version of this phenomenon in the S&L crisis: the prime rate wasn’t all that bad, but it was irrelevant because just about no one could borrow in any meaningful size.
Now if you don’t think the credit crisis has further to run (credit contraction is deflationary), then raising rates is in order. But based on what I see, things are plenty fragile. I’d rather have the central bankers simply sit tight and do nothing for a quarter and try to get a better handle on the fundamentals.
We’ll admit that in a solvency crisis, there is not much a central banker can do. But raising rates now, particularly in pursuit of a dubious notion like inflation targeting, is in its own way as precipitous as Bernanke’s 75 basis point cuts.
First, some comments from Banque AIG market strategist Bernand Conolly (hat tip reader Scott, no online source). The subtext is that he sees no pretty way out of the mess of massive US debt overhang, but efforts to force US rates up now could produce a particularly devastating resolution:
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W]hat we are seeing in the world is a breakdown of international economic consensus. In its place is what the literature calls “strategic behaviour”, marked by threat strategies and an underlying feeling of every man for himself….
Our main concern today, though, is with the damage that will be done to the world economic and financial system if the US gives in to threat strategies, whether from the ECB, from europols or from elsewhere in the world. If one looks at the Saudi position, for instance, it is very understandable indeed that the Saudi authorities should be seriously concerned about the erosion of their country’s purchasing-power over rest-of-the-world resources as the dollar has depreciated. But that simply restates the impossibility of achieving a fundamental equilibrium in the US. As we argue in some detail in our note, “Central Banks, Asset Prices, Risk Premia, Money and the Macro Paradigm: Where Does It All Point?” of 19 February 2007, the US current-account deficit has been a Ponzi game: market pricing has implied that holders of claims on the US economy will see the value of those claims (in terms of command over future US resources) go towards zero as time goes towards infinity. There is an agent-principal problem here that relates to the possibility of a self-fulfilling equilibrium with an inefficient outcome: those in charge today of managing their countries’ claims on the US have an incentive not to inflict realised losses on their principals by sparking a dollar rout, even though, in the limit, not bailing of claims on the US now may mean that future generations will find those claims worthless.
But the Saudis, at least, now seem to have understood at least one aspect of the problem. Unfortunately, a combination of Saudi pressure on the US to stem dollar depreciation and europol pressure on the US to try to do that by forcing US rates up could bring disaster. Recall the analysis of the relevant part of our note of 19 February last year. The scale of real effective dollar depreciation required for the US to be able to respect its intertemporal budget constraint without a devastating US
recession was simply not reflected in real-interest-rate differentials. That left two possibilities. One was that the Ponzi game would be allowed to run on indefinitely: the US would not respect its transversality constraint and the rest of the world would not meet its transversality condition. The other was that the US current-account deficit would indeed adjust but, without the support to net exports from a massively-depreciated dollar, that adjustment would take place in conditions of devastating recession. But in that scenario US credits would deteriorate dramatically; yet that, too, was not incorporated in market pricing.The horrible prospect is that the europols are trying to subject the US to the constraints that EMU has imposed on the euro-area cads. In EMU, currency risk (for individual countries, though not of course for the area as a whole) is transformed into credit risk. But if that happens to the US, via attempts to “stabilise” the dollar, the catastrophic impact on US credits will – given that the dollar has been essentially a credit story in the present decade – lead to very severe downward pressure on the dollar as foreigners are forced to try to bail out of claims on the US. That vicious circle would be broken, no doubt, either by a decision by the US authorities to let the dollar go – in chaotic circumstances recalling the end of the Bretton Woods system but probably with even more profound geopolitical consequences – perhaps after intervention/exchange controls on one side or the other.
Ambrose Evans-Pritchard of the Telegraph is largely on the same page.
Sadly, we are witnessing the sort of strategic errors that turned the recession of 1930 into a global catastrophe.
The European Central Bank is now hell-bent on a course of action that will have a knock-on effect across the world and risk a dangerous implosion of the credit system.
The ECB’s Jean-Claude Trichet told Die Zeit today that “there is a risk of inflation exploding.”
Let me put it differently: there is a grave risk of social and political disorder “exploding” if the logic of his argument is followed to its grim conclusion, that is to say if the ECB charges ahead with a string of rate rises through the autumn after its near certain move to 4.25 per cent on Thursday.
The ECB mantra is that Europe and the world is on the cusp of a wage-price spiral along the lines of the 1970s…By taking this militant 1970s line, he is in effect kicking Bernanke in the teeth. Or put another way, the ECB is trying to pressure America into a tighter monetary stance. Regrettably, this has in part succeeded. The Fed badly needs to cut rates further — probably to 1per cent. It cannot do so because the ECB keeps threatening to pull the plug on the dollar.
This is madness. It is the mirror image of the early 1930s, when the Federal Reserve (cowed by the Chicago liquidationists) precipitated the collapse of 4,000 banks, and transmitted their fervour to rest of the world through the Gold Standard. This time there is no Gold Standard. But the globalised capital and currency markets — egged on by Trichet — are playing much the same role.
Yes, eurozone inflation reached 4 per cent in June. But what on earth does that tell us, unless you are an inflation-target totemist? It takes two years or so for the full effects of monetary policy to work through the economy, and by then Europe will be an entirely different place.
The ECB was too loose in the early part of this decade (in order to help Germany), keeping rates at 2 per cent until December 2005. That is the underlying cause of the rapid credit growth in the eurozone up to the onset of the credit crunch, and a key cause of silly property bubbles in Club Med and Ireland. The ECB was negligent in 2004, 2005, and 2006, (as were the US Federal Reserve and the Bank of England — this is not to absolve Anglo-Saxon central banks at all. They all botched royally.)
We are now in the eye of the post-bubble, debt-deleveraging, deflation storm. The ECB’s rate rise tomorrow will do nothing whatever to deal with the current oil and food spike, which is in any case causing a dramatic squeeze in real wages. It will merely make the downturn worse. I suspect that the ECB will be cutting frantically to undo the damage from its own ideological excesses soon enough, just as the Fed had to do after its fatal rate rise to 5.25 per cent last year…
If the rate rise pushes the euro higher against the dollar, it will merely push oil higher as well — since oil is trading as inverse dollar with seven times leverage. Eurozone “inflation” — that treacherous term — will get worse. Brilliant.
Ben Bernanke — despite his own “helicopter” baggage — has had the courage to ignore the shrieking punditocracy and slash rates by 325 basis points, looking beyond the oil spike to the deflationary risks that lie beyond. This is statesmanship of the first order….
Perhaps Germany now needs higher rates as unemployment tumbles to a 16-year low. It has gained 30 per cent to 40 per cent in unit labour competitiveness against Italy and Spain since the currencies were fixed, and 20 per cent against France.
It is conquering market share across Club Med. As chief supplier to booming Russia, it is enjoying a (positive) asymmetric shock. But Germany is not the euro-zone.
The unspoken truth — and now the source of so much poisonous policy-making — is that Europe signed an implicit political contract with Germany in the 1990s that monetary union should never lead to a recurrence of German inflation. The euro must be as hard as the old D-Mark, and not a Lira-Peseta.
The system is now being bent to comply with this contract. Indeed, one senses that Buba chief Axel Weber has a near maniacal urge to press the point, like Shylock cutting his `Pound of Flesh’, — even if such a course of action has become inherently destructive, especially for Germany’s strategic interests….
As the BIS and others have warned, the eurozone is already in the grip of an incipient credit crunch. Distressed companies are drawing down existing loans from banks because the securitisation market is shut.
The result of monetary overkill is already evident in parts of system. Ireland’s GDP contracted at an annual rate of 1.5 per cent in the first quarter. It will get a lot worse. Investment fell 19.1 per cent. House prices have fallen for fifteen months in a row.
Spain’s house prices have fallen 6.2 per cent since July (4.3 per cent this year alone) according to Facilisimo.com. This hardly surprising. Euribor used to price floating rate mortgages (98 per cent of the total in Spain) has risen 120 basis points since the crunch began.
Unemployment has risen by 425,000 over the last year, a faster rate of increase than during the recession of the early 1990s. Monetary policy has been tightened into a severe downturn.
HSBC expects French house prices to fall 10 per cent over the course of this year and next.
Yes, inflation has run amok in Asia, the Mid-East, and Russia. They will have to slam on the brakes. Some are doing so already. This will hit just as the effects of the ECB’s squeeze bites harder.
It has become fashionable to talk of “global inflation”. There is no such thing. A large number of countries have let their money supplies surge out control by refusing to let their currencies revalue against the dollar. They are now paying the price.
The Western states with collapsing property and asset markets (the Anglo-Saxons, Club Med) or demographic implosions (Germany) have the opposite problem. Confusing one with the other will take us straight into a slump.
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> Sadly, we are witnessing the sort of strategic errors that turned the recession of 1930 into a global catastrophe.
I’m not sure that Haitians or people of other devloping countries would agree with Ambrose Evans-Pritchard about the best policy for interest rates.
Haiti’s poor resort to eating dirt
http://www.msnbc.msn.com/id/22902512/
“Or put another way, the ECB is trying to pressure America into a tighter monetary stance. Regrettably, this has in part succeeded. The Fed badly needs to cut rates further — probably to 1per cent. It cannot do so because the ECB keeps threatening to pull the plug on the dollar.”
Ah yes, all the Keynsians are preparing the ground for the idea that it wasn’t their bad advice all these years which helped create the problems, it was the ECB (those French!) raising rates a measley 0.25 percent.
What is this “pressure”? What is this “pulling the plug”? The ECB is an independant actor, in no way beholden to the Fed or the U.S. It can and should do what it wants. If it raises rates 0.25% and that means the U.S. doesn’t think it can lower rates, then so be it. Let a thousand (or at least 2) flowers bloom. Let the markets decide – a currency with a rate of 4.25% and a currency with a rate of 2%.
Anyone who thinks the solution to America’s problems is to lower rates to 1% is a fool.
On the other hand, the best thing any sage can offer now is advice that won’t be adopted. Things are going to turn out badly no matter what path we take; better down the road to be able to say, “You can’t blame me. I wanted to do things differently.”
a,
Conolly’s piece, in a section I omitted, had a long discussion of the politics. He (and he like Evans-Pritchard is based in London) sees the rate hikes in part motivated by a desire to force the US to act. He goes on at considerably greater length, but here’s the gist:
But the ominous relevance of the 1987 analogy has been made more evident by this morning’s astonishing comments from Jouyet to the effect that ECB rate hikes will be acceptable if they force the Fed into hiking US rates and supporting the dollar. What is Jouyet playing at?
Second, I don’t think E-P sees 1% rates as a solution. He is an Austrian. I think he simply sees it as the least bad in a set of lousy options.
As I said, I’d rather see the Fed hold, but would say the odds are high we will be at 1%. The wheels are coming off the financial system.
Yves, well the Fed is an independant player. If an increase of 0.25% in an interest rate of a foreign currency forces its hand, it doesn’t have any hand to begin with.
I think you have to understand the political context of Jouyet’s remarks. The French are gnashing their teeth at the prospect of another ECB rate increase and more EUR strength vs the USD. So Jouyet comes along and offers a counterargument, “No look, rate increase here actually means USD strength!” You can believe it if you want. Or not.
Basically the Anglo-Saxons are looking for a fall guy. It can’t be their own incompetence and corruption. No it has to be the foreigners, and a measley 0.25% rate increase in someone else’s currency, which is causing their problems.
One other remark if I may!
“Spain’s house prices have fallen 6.2 per cent since July (4.3 per cent this year alone) according to Facilisimo.com. This hardly surprising. Euribor used to price floating rate mortgages (98 per cent of the total in Spain) has risen 120 basis points since the crunch began.”
This of itself discredits Evans-Pritchard. To pretend that the fall in Spanish prices is because of the increase in mortgage costs clearly puts him in the camp who doesn’t understand that what goes up, must come down, one way or another. Spanish housing prices were ludicrously too high, they had only one way to go – down. The ECB could have lowered their rates to 2% and the bubble would still be collapsing – just like in the US.
Raise rates or not the issue of confidence for investors in credit markets needs to be addressed.
A decline is likely to continue until the mess clears and investments can be made with some degree of clarity.
Improprieties and irregularities must be exposed, prosecuted and worked through so that investment can flow back into markets with a somewhat restored level of confidence.
Raising rates now, or holding off will not help without increasing transparency and confidence.
Excellent – you nailed it.
The last time I checked, the purpose of increasing policy rates was to tighten credit conditions via pricing.
There seems to be a wee bit of that effect happening without the Fed’s help.
Moreover, the Fed in its recent missives has not once indicated it expects to increase policy rates. It’s only indicated its closely monitoring inflation expectations – which happen to be an indelible line on the job description.
Only another article from Ambrose Evans-Pritchard to blame the Germans for the hole mess.
So they have to be the scapegoat again.
I Think he a little bit germaophil.
To me, the issue of the ECB putting upward pressure on eurorates needs to be recast in a different context. The currencies of most if not all major economies are presently yielding _negative real rates_. This issue has yet to fully enter the policy debate, but to me it is THE key issue. I do not think Trichet is such a fool as to _really_ see a wage-price spiral in the offing: the wage pressure in the Eurozone just isn’t there, and the price pressure on commodities is external to Europe AND DOLLAR DENOMINATED. The last is key. A cheaper $ equals higher oil and commodity prices, both due to pegs and to pricing. Any hope of restraining further commodity price escalation depends on preventing further $ declines at least, though by itself this won’t be sufficient. Still, pressure to stabilize or raise the $ is the inescapable policy conclusion which follows from any committment to brake commodity price rises.
We got into the present badly distorted global financial far from equilibrium state by exactly this method of pervasive negative real interest rates, the eyepoppingly low level of interest rates which together with systematically underreported inflation has had much of the global economy in negative rate territory through ten years, and the US there for twenty. Negative rates, furthermore, feed speculation, both by facilitating carry trades and by devaluing fixed income positions. There is no way to me, NO WAY, that present global financial instatility can be contained without getting global rates back to at least a neutral value; this reckless floating of credit in pursuit of vapor-growth has to be reined in. That means, well, _higher rates and harder currencies_. I think the ECB understands this much better than anyone else. They have had the lesson of Club Med in their midden garden, and they are the ones plugged in closely to unsterilized and uncontained inflation in Russia and unsound wildcat bank lending in Eastern Europe. I’m not saying that the ECBs rate rises are a perfect solution, but the are surely a rational one.
Now, it does follow that if the US were to raise rates the tenuous fabulation that the US banking systems is solvent as of July 08 becomes an untenable untruth. —But that IS the truth, is it not? Are we, then, to lug dead megabanks around on our backs for a decade before confessing failure? Or would it be better to begin thinking about a runoff of the worst rotting zombies while the public authorities still have the funds to fold them up? Bear in mind that major international public financial authorities have _NOT_ deserted the US to this point. If, as Brad Setser demonstrates convincingly, it is the purchase of Treasuries and Agencies by foreign public financial authorities which has for the whole of the last year kept the US economy afloat, that is a strong indicator the we will get real foreign backing for a ‘reorganization plan’ for our domestic banking system. If. If we play ball, and get our frickin’ reserve currency back to something at least as firm as jello and keep it there. ‘Cause our neg real rates are a MAJOR contributor to globally disruptive commodity speculation. Not the only contributing factor be it said, but the sine qua non.
I also view the mooted mass closure of factories in Guangdong as a positive sign for the gradual wind down of global imbalances. China has been vendor financing to the US out of such factories with negative interest rate credit in an environment of heretofore affordable commodities. Now, they have spiraling inflation from unsterilised purchaser $ credit and suffocating commodity prices. Sooo their part in the equation is to cut out some of that destabilizing and now unprofitable export production. —But the US has to play ball, too, to keep those foreign bond buyers in the money. That means rising US rates, by autumn at the latest.
I’m not too keen on the US banking system going bust in this process unless the rest of the world helps us get together quickly enough pieces to make a new whole. But it looks to a degree as though they will. If it takes a realized deflation in Bubblemerica to bring down severe inflation in much of the rest of the globe, the rest of the globe’s central bankers are going to vote for that outcome. And we are not going to have any real choice because we won’t get any kind or real or comparatively rapid recovery without their help. . . . Soooo, let’s get on with it. Negative real rates are the real enemy, and in the main that enemy is us. The rest of the world is telling us this, semi-politely and behind closed doors. If necessary, be sure that they will tell it to us in anger from behind barred doors.
And a, I’m in agreement with most points in your comments, most especially that Anglo-American hypocrites want a foreign fall guy for their own feckless financial incontinence. But you misuse the label of Keynesian in describing public monetary policy in Anglo-America of recent years, I think. No legitimate Keynesian would have kept interest rates negative or low in times of nominal economic expansion. No, this was Long Boom Exceptionalists.
Bernard Connolly’s writing is available at:
http://www.aigfp.com/home/research/strategistviews
It is hard going (because Bernard writes such complex sentences) but highly nutritious food for thought. The problem I have with his view though is that, while saying that it would be disastrous to stop the Ponzi game that the US has got into, he does not suggest another way out.
As for the Fed’s role in this, I offer some evidence myself at:
http://reservedplace.blogspot.com/2008/06/greenspan-put.html
The reason Ambrose E-P insists that the ECB is doing all that for Germany is, that he doesn’t understand, that Germany has more people than Ireland and Spain and Portugal and Greece together.
The ECB has to take the countries into account proportional to their economic weight. Furthermore 2003-2005 France and Italy were as well not growth miracles.
a: Your takedown is fundamentalism at its best. It really is that simple, isn’t it? (And rk added a nice chunk of meat to those bones for people who need the reconstruction.)
Yves, Richard,
great points.
Richard you nailed it. The hard looking way its the one to go but it looks politically infeasable at least for this administration and with Bernanke as chief-misinterpreter of the Great Depression for the Fed too. If we are lucky, Obama will go this way.
But that would mean early next year, not 2008.
Yves, you see rates going to 1% instead.
Certainly both is possible and but more probable looks a political middle way, staying at 2% for 2008.
How do you see both of you probabilities in FedFunds for the rest of 2008?
Me: up 10% – stay 70% – down 20%.
Hubert,
How one assigns the odds has a lot to do with how one sees the likelihood of more serious trouble in the financial system, like another ratcher up in the TED spread or a major institution going over the cliff. I think you’d see a Fed cut accompanied by lots of hand-waving.
“Remember, the reason high interest rates kill inflation is by slowing economic activity”
Interesting. Zimbabwe must be the country with the most active of the world economy.
A great take on the present situation with excellent comments. Richard Kline’s is superb.
A thought posted elsehwhere. We know markets often test central bank/government resolve. Is that what is happening with oil? Is the oil market saying to Bernanke & Co: We dare you to raise rates! You haven’t got the gumption to do so.
Interest rates may drop to 1%, but only in response to crises, and not below 1%. Lowering rates below 1% will start to put money market funds out of business. ZIRP hurt them badly in Japan, and they have enough political power to prevent the Fed from pursuing ZIRP. For example, the mutual funds are pushing through legislation right now to reduce the benefits of ETNs, even though SIFMA is fighting them.
Trichet has upped rates by 0.25%. Oh my goodness what a big deal. At the same time he hints that it is NOT necessarily the prelude to further rate increases. So what is it? A token rise, a warning that ECB could, might, get tough if inflation shows no sign of abating. But will it if Europe data begins to show general weakness and inflation sticks around 4%. Hmmm. We are not sure now are we? They might well bend and do a Fed.
We musn’t get all weak kneed about this. The old saying that “It’s hard to drain a swamp when you’re up to your arse in alligators,” applies perfectly here. Of course there are nasty flesh eating monsters out there but we have to drain the excess liquidity. Yes, indeed, there will be insolvencies. And some very rich people will become “merely” rich.
I think Trichet is completely right in his actions. He realizes that the Fed is currently run by an idiot who is on record as saying that a falling dollar doesn’t have much impact on Americans because they buy most of their stuff locally. A chairman who is on record as saying that we have a technology, the printing press, that can see to it that deflation never happens.
Bernanke, in his more polished way, is as incompetent as Bush. He needs to be taken out to the woodshed and given some painful lessons. Good for Trichet!
When the liquidity is removed energy prices are likely to stabilize. And, yes, it’s going to hurt a lot of people to do that. You’re the one always lionizing Paul Volcker. When it comes to walking the walk apparently you’re not so brave.
How funny that the OP and the comments go on and on about macro economic consequences the world over to Fed actions, but not a word is spoken about the one group that 1) cares the most about fed actions, and 2) (and critically) the fed (quite clearly) cares the most about — US financial firms, and stock market actors.
Golly, as long as the fed holds rates at effectively negative, do you think folks on Wall St. might try to borrow and then play short term moves on wall st? Nah, who would do something like that.
Golly, if history, and attitudes expressed in public are any guide, one might think that the Fed is trying to blow a stock market bubble to cover the collapse of it’s housing bubble.
The idea that the fed gives two figs about any of the issues discussed above is tentative at best. The reality is that we have a federal system dominated top to bottom by people intent on using it (the government) to promote the interests of the largest corporations in america. They have no other agenda.
All this economic talk is hilarious. Oh and by the way: it is precisely all these ‘free Market’, supply and demand is the only truth, government is the problem, con artists, who are most directly responsible for the current state of affairs. They deliberately (and quite high mindedly) set out to create a situation in which the government was either broken, or taken over for the benefit of ‘the market’, and now attempt to use the fact that government is broken and only works for the benefit of the market as ‘proof’ that government is the problem. Disingenous con artistry at it’s absolute finest. I hope your portfolio is 10M+ … you’re kids will need it.
Agree, agree, agree. Yves, thank you for saying what I couldn’t have said much better. Evans-Pitchard has it right, too.
Do you know who else isn’t getting credit? Speculative shorts in the oil market. That article you quoted was illuminating:
http://uk.reuters.com/article/oilRpt/idUKN0155978220080701
I can’t say I understand, or want to understand, the relationship between spot and futures in oil, can’t arb the prices because of storage issues, blah, blah, blah, but buying and selling I have experience with. I’ve been wondering where all the shorts in oil futures have been. But if they can’t get credit to short it, well, where else can prices go? The “fundamentals” don’t justify this move, bubble psychology is operating now, full-bore; shorting is certainly frightening here, but eventually, the price will get high enough for the sellers to come out and drive it down. Well, unless they can’t because of financing issues or regulatory ones.
As for the independence of the ECB and their need to exert Teutonic restraint on the rest of the world (yes, I know Tricky’s French), or the need for years of “pain” and “austerity” to, well, I don’t know what that is supposed to do, “cleanse” us of our moral failings as consumers or Americans, be careful what you wish for.
Shooting yourself in the face to spite the big toe doesn’t make a pretty picture.
Per the assertion that Germany has more people than the EU members that are having a wee bit of trouble, that’s incorrect.
Per Wikipedia, population in millions:
Germany 82.8
Italy 59.3
Ireland 4.2
Greece 11.1
Portugal 10.6
Spain 45.1
Sum of last 5 130.3
As for the liquidationist view, I am no fan of Wall Street, but I don’t see the current measures by the Fed as serial bubble blowing, more as panic when the financial system looked on the verge of implosion. The assets that everyone is trying to shore up are mortgages, Mark those to market and there may be zero equity in the banking system. Congress is as keenly on this mission as the Fed.
Hedge funds have have their borrowing facilities cut, margin on stock trades is at cyclical highs about 2% of outstandings. One theory as to why commodities are hot it that they are the last game that does NOT require leverage from the banking system. Commodities futures require low margin deposits.
If you do let liquidation proceed, then you need a plan to recapitalize the banking system, pronto. The Japanese have even said that publicly, which is highly unusual for them. We don’t seem to have any such program in mind. I don’t think anyone in the officialdom is willing to go hat in hand to China and the Gulf states and risk being rebuffed.
Rebel Economist:
You were a central banker and you admit it publicly?
The world as we know is over. I have a great position in equity research. But, I expect to lose my job when the depression hits. I am trying to figure out a new career path before the tide really turns, maybe in nursing or another healthcare-related field. To say I am worried about my future at the age of 30 is a massive understatement.
I know I’ll be drinking this 4th of July weekend.
I nominate LJR’s message for “post of the year”. I live in the States and couldn’t agree more with his conclusion. Well said!!!
LJR said…
We musn’t get all weak kneed about this. The old saying that “It’s hard to drain a swamp when you’re up to your arse in alligators,” applies perfectly here. Of course there are nasty flesh eating monsters out there but we have to drain the excess liquidity. Yes, indeed, there will be insolvencies. And some very rich people will become “merely” rich.
I think Trichet is completely right in his actions. He realizes that the Fed is currently run by an idiot who is on record as saying that a falling dollar doesn’t have much impact on Americans because they buy most of their stuff locally. A chairman who is on record as saying that we have a technology, the printing press, that can see to it that deflation never happens.
Bernanke, in his more polished way, is as incompetent as Bush. He needs to be taken out to the woodshed and given some painful lessons. Good for Trichet!
When the liquidity is removed energy prices are likely to stabilize. And, yes, it’s going to hurt a lot of people to do that. You’re the one always lionizing Paul Volcker. When it comes to walking the walk apparently you’re not so brave.
Yves, great post. RK et al tremendously vibrant discussion and comments. Seems like we’re balanced on a high wire.
As one who came of age during the late 70’s and early 80’s, I think the severity of today’s problems are different but no greater than the dangers we experienced during that period:
– only 5 years beyond the Viet Nam defeat
– High inflation
– Low productivity
– An oil shock
– Iranian hostage situation
– USSR invading Afghanistan
– Chinese invasion of Viet nam and the associated increased tensions along the Sino-Soviet Border
– Mortgage interest rates that went through the roof
– US manufacturers getting creamed by Japanese companies
– Stagnant stock market for more than 15 years until 1982/83
(Remember the rumor that the Delaware Fund was going to collapse because of overinvestment in Eurodollars-whatever that meant?
There was just a tremendous sense of gloom and explicit concern that the entire financial system would collapse. Things weren’t pleasant but we got through it.
I also think we’ll get through this more quickly if leaders take appropriate steps. I think Richard Kline’s logic about higher interest rates, as usual, made the most sense. The alternative would be as he said “…Are we, then, to lug dead megabanks around on our backs for a decade before confessing failure? Or would it be better to begin thinking about a runoff of the worst rotting zombies while the public authorities still have the funds to fold them up?”
That’s the trade-off.
Howver, I can understand the reaction of Anon @1;56. He’s a youngster. Have to admit that there were a more than a few weekends back then when I knocked a few back, to forget about what was happening in the real world.
The real underlying problem is the Brobdingnagian vendor financing frauds perpetrated by the Asian governments through their mercantilistic foreign exchange rate manipulations — China (and others) directly through pegged exchange rates, Japan indirectly through its ZIRP and implicit guarantees that it will never let ZIRP-based carry trades go bad.
Prices that reflect the real value of economic resources are the fundamental underpinning of a market economy.
Prices falsified through exchange rate manipulation fundamentally undermine the world’s economic system and force suboptimal equilibria.
Exchange rate manipulation perverts and subverts markets.
The only reason that the US has been able to overconsume as it has is that Asian governments have subsidized their exporters by promising to buy all the dollars they bring in at exchange rates having no relationship to those dollars’ true value, and have then lent the dollars back to us at rates sure to result in a loss due to the loss of American productive capability resulting from destruction of goods-producing industries, and to the malinvestment in retailing and distribution capacity needed to move all those imports into consumers’ hands.
The world economy has been distorted as if in a fun-house mirror. It doesn’t matter what central banks do. What needed to be done is imposition — long, long ago — of countervailing duties to counterbalance the Asian exchange rate manipulation subsidies. It’s way, way too late. Far too much damage has been done.
Here is a novel idea: all the central banks should now do NOTHING and simply let the credit markets in their respective countries dictate interest rates, which would guarantee more sanity and a lot less instability.
Keep the money supply under control as well, and let asset price discovery take its course. More economic damage has been done by the Fed’s panic rate cuts than by simply letting a few big broker-dealers blow up.
Independent Accountant,
Yes, I was central banker once, but I was too conservative to fit in.
leftback: “Here is a novel idea: all the central banks should now do NOTHING and simply let the credit markets in their respective countries dictate interest rates, which would guarantee more sanity and a lot less instability.
Keep the money supply under control as well, and let asset price discovery take its course. More economic damage has been done by the Fed’s panic rate cuts than by simply letting a few big broker-dealers blow up.”
Andrew Mellon, Treasury secretary 1921-1932: “Liquidate labor, liquidate stocks, liquidate the farmes, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”
So Yves, I couldn’t agree more that a functional plan to recapitalize the US banking system is the key mechanism needed for the US to move forward in a global macrofinancial realignment. I don’t think that the present idea of foreign major capital—read the Gulfies and China and its cubs—is a go. They stand to lose money by direct investment, and there are twisty political ramifications from such stakes. In any event, those foreign sovereign moneybags haven’t moved en masse, and they would be crazy to do so before US financial institution prices bottomed which as I know that you know is something very far from present valuations.
What likely needs to happen is for a US public body to be capitalized out of the Fed or Treasury, which then sells bonds guaranteed by the US and in turn places capital stakes in the salvagable portion of the major US financials. Guaranteed ‘financial agency bonds’ out of the intermediary institution can quite possibly be sold to that sovereign foreign capital because not only will they not have to invest in US banks directly but also there stands to be a secondary market for the paper in time.
This sounds complicated but then the situation _is_ complicated. I suspect that the ultimate resolution to the US financial system crisis will look much like this. But we need it in the next six months whereas we are more likely to get it twenty-four months and more down the road after wasting a lot of time and an enormous amount of money trying to defend indefensible market-top valuations in the big financials, equities, and US mortgages. If the US had any real leadership, economic or political, we would be hearing the first discussions of such an approach. We don’t have leaders in this country, though . . . only players.
Andrew Mellon, Treasury secretary 1921-1932: “Liquidate labor, liquidate stocks, liquidate the farmes, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”
I always get a big laugh when people put up this quote. Apparently they’ve never heard about the equally famous quote of generals always fighting the last war.
The credit at 2% well where is it going? Consumers are or are not seeing it? Will they see it at 1%?
Would the credit contraction be deflationary it had not been overextended?
Price vs availability… if no credit available then what consequence the price?
Does market price for credit reflects inflation expectations, and compensation for expected credit losses/default, or something else?
Is the securitisation market shut?
Have Spain and France’s property markets been driven at the margin by UK demand, where rates are higher than in Europe.
Yen has strengthened against dollar despite interest differential
Euro strength is dollar weakness
Anglo saxons have demographic hump to work through too
There is a big blame game being attempted by certain quarters.
I see the ECB as having made the right decision. Rates in Europe and the US are too low. Even the British, the Australians and the Kiwis have higher rates.
Easy money leads to ruin over the long-term as it only encourages additional debt build up. I don’t buy the argument that systemic risk is too high, so let’s lower rates. If some financial service companies cannot operate in a normal interest environment, they are essentially bankrupt and should be liquidated.
See a fuller explanation from me here:
http://www.creditwritedowns.com/2008/07/ecb-is-right-and-fed-is-wrong.html
I believe things will get worse, and that the Fed should raise rates. of course this is contingent on the idea that the ECB should also cut rates. If the ECB is worried about inflation “exploding” this simple act will help cool it off as much of this is because of oil becoming a new currnency. this will not end the trend, but rather should cool the effects and re-establish inflation fighting credibility to the Fed.
as for the timing of this act, i dont think it will nor should happen in the summer, but should before the year is done.
This mess was created by the Bush regime and the fed. After 9/11 they printed dollars like it was no tomorrow.
The ECB should continue seving EURO zone interests, not bailing out the US.
Let America sink.