Paul Krugman is writing about The Face-Slap Theory.
The scariest thing I’ve read recently is a speech given last week by Tim Geithner, the president of the Federal Reserve Bank of New York. Mr. Geithner came as close as a Fed official can to saying that we’re in the midst of a financial meltdown.
The Fed’s latest plan to break this vicious circle is — as the financial Web site interfluidity.com cruelly but accurately describes it — to turn itself into Wall Street’s pawnbroker. Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.
Drop In The Bucket
Several people have asked me recently if I have been changing my tune on a Fed bailout. The answer is no. I long ago predicted the Fed would try all sorts of things to stop a deflation threat. But I also have also said, these measures would not work and indeed they haven’t. What is happening is the Zombification of Banks, that is exactly what happened to Japan as well.
From Krugman: $200 billion may sound like a lot of money, but when you compare it with the size of the markets that are melting down — there are $11 trillion in U.S. mortgages outstanding — it’s a drop in the bucket.
The Red Queen Race
On two prior occasions I have likened the liquidity efforts of Bernanke to The Red Queen Race. Here it is again.
In Lewis Carroll’s Through the Looking-Glass there is an incident involving the Red Queen and Alice constantly running but remaining in the same spot. The scene is often referred to as The Red Queen’s Race.
The Queen kept crying “Faster!” but Alice felt she could not go faster…
“Now! Now!” cried the Queen. “Faster! Faster!” And they went so fast that at last they seemed to skim through the air, hardly touching the ground with their feet, till suddenly, just as Alice was getting quite exhausted, they stopped, and she found herself sitting on the ground, breathless and giddy. The Queen propped her against a tree, and said kindly, “You may rest a little now.”
Alice looked round her in great surprise. “Why, I do believe we’ve been under this tree all the time! Everything’s just as it was!”
“Of course it is,” said the Queen: “what would you have it?”
“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else — if you ran very fast for a long time, as we’ve been doing.”
“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”
The above image is thanks to the University of Virginia Library.
Bernanke, like the Red Queen and Alice, simply cannot run fast enough when it comes to bailing out this financial mess.
Why Measures Fail
Face Slapping, the TAF, the PAF, lowering interest rates etc. are measures that can only work if the problem is lack of liquidity. The problem is not one of liquidity. The problem is solvency. Massive amounts of credit was created out of thin air because fractional reserve lending allows it. Speculation in assets went through the roof when the Fed held interest rates too low too long.
Now with falling asset prices, margin calls are running rampant. Margin calls beget margin calls in an ever escalating chain reaction. Carlyle Capital, a once $32 billion fund, was Hit With Margin Calls And Default Notices. It may have to liquidate. If it does, most of that $32 billion will be wiped out because of the 32:1 leverage it was using.
For those who want a Seasonal Lenten Message here it is: Remember credit that thou art dust and to dust thou shall return.
Remarks by Timothy Geithner, President New York Fed
Let’s now turn our attention to the speech that has Paul Krugman spooked: The Current Financial Challenges: Policy and Regulatory Implications. It’s a long speech in which Geithner attempts to spread the blame around.
“ The origins of this crisis lie in complex interaction of number of forces. Some were the product of market forces. Some were the product of market failures. Some were the result of incentives created by policy and regulation. Some of these were evident at the time, others are apparent only with the benefit of hindsight. Together they produced a substantial financial boom on a global scale. “
There were complex interactions for sure but blaming market forces is lame. The second sentence gets to the heart of the matter. I suggest these problems were entirely “the result of incentives created by policy and regulation“.
Of course few see it that way. Many are blaming lack of regulation, specifically the unwinding of the Glass-Steagall Act for its role in this mess. Such blame is ill placed as discussed in Did Lack Of Regulation Cause This Mess?
Root Cause Of This Financial Crisis
- The Fed
- Fractional Reserve Lending
- Government sponsorship of the rating agencies (See Time To Break Up The Credit Rating Cartel)
- Government sponsorship and promotion of housing via GSEs, tax breaks, etc.
There is not a free market failure in the group, nor will there ever be.
Although Geithner fails to understand the cause, he does paint an accurate picture of the chain of events leading up to the crisis.
- Real short-term interest rates were reduced around the world.
- Global savings appeared to rise faster than did perceived real investment opportunities.
- Emerging market economies built up very large levels of official reserves to hold the value of their currencies stable against the dollar.
- The exchange rate policies in those economies made overall global financial conditions more accommodative.
- Expected and realized volatility in both debt and equity markets dropped. Term premiums declined and remained low.
- Credit spreads across a wide range of asset classes fell to levels that assumed unusually low levels of future losses.
- Many households, including those previously lacking access to credit or with access only to expensive credit, found they could borrow on a significant scale to finance the purchase of a home and other expenses.
- Prices rose across a range of real and financial assets, most notably the prices of homes.
- This constellation of broad economic and financial conditions was accompanied by rapid innovation in financial instruments that made credit risk easier to trade and, in principle at least, to hedge.
- Issuance of asset-backed securities (ABS), collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs), as well as credit default swaps (CDS), expanded on a dramatic scale.
- The proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity.
- A sizable fraction of long-term assets—assets with exposure to different forms of credit risk—ended up in vehicles financed with very short-term liabilities and was placed with investors and funds that were also exposed to liquidity risk.
Self Reinforcing Action
Continuing the discussion from Geithner:
The self-reinforcing dynamic within financial markets has intensified the downside risks to growth for an economy that is already confronting a very substantial adjustment in housing and the possibility of a significant rise in household savings.
The intensity of the crisis is in part a function of the size of the preceding financial boom, but also of the speed of the deterioration in confidence about the prospects for growth and in some of the basic features of our financial markets. The damage to confidence—confidence in ratings, in valuation tools, in the capacity of investors to evaluate risk—will prolong the process of adjustment in markets. This process carries with it risks to the broader economy.
For more on self reinforcing action, please see the excellent discussion on Daisy Chain Reactions by Professor Bennet Sedacca in Changing the Benchmark.
Fed Has No Confidence In Monetary Policy
“We cannot know with confidence today what level of the short-term real funds rate will be consistent with our objectives of sustainable growth and low inflation, but if turbulent financial conditions and the associated downside risks to growth persist, monetary policy may have to remain accommodative for some time.”
There you have it. That is an explicit comment from a Fed Governor that they have no idea with any confidence they know what they are doing.
I Have 100% Confidence
On the other hand, I have 100% confidence they have no idea what they are doing. They can no more accurately fix the interest rate than they can fix the price of orange juice. Heck, in actual practice, the latter would be far easier.
Fed Attempts To Wash Hands
Sadly Geithner sticks to the myth that this was not preventable.
“Was this preventable? I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks.“
Of course it was preventable. Two simple measures would have prevented 80% of this mess: Elimination of the Fed, and elimination of fractional reserve lending.
Three Part Solution
Geithner’s speech goes on and on and on. Still, it is probably one of the most important speeches ever by a Fed governor in admitting what the problems are. I recommend reading it in entirety. And while the Fed (at least Geithner) admits it has no idea what to do, I offer this 3 part solution.
- Abolish the Fed
- Eliminate fractional reserve lending
- Implement a sound monetary policy based on hard assets such as gold as opposed to price fixing by government sponsored clowns
Mike “Mish” Shedlock
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