Messrs Geithner, Bernanke, and yet another gentleman from the former investment bank Goldman Sachs, (Bill Dudley who replaced Geithner as President of the NY Fed), went before the House Financial Service Committee to answer questions about the AIG bailout today .
Notwithstanding the alternately inane, occasionally relevant but hopelessly mangled, or just downright painful questioning from House members typically out of their depth, ie: the usual, m* was rather looking forward to today's hearing. The opportunity to focus attention on the decision process behind one of the most extraordinary actions taken thus far in the crisis, the initial and now ongoing operation to keep AIG on life support, seems long overdue.
Mere hours after Lehman Brothers was inartfully "allowed" to file for bankruptcy (most market participants having been lulled into complacency by the extraordinary measure of a $40bn Fed loan to JPM to help smooth the passage of Bear Stearns into its long goodnight), the Fed and Treasury reversed course, again, and advanced AIG $85bn (for 80% of the firms equity) to meet collateral calls from its trading counterparties and prevent a bankruptcy.
The justification put forward at the time, that a "disorderly" bankruptcy risked unknown but assuredly catastrophic effects on the financial system and the economy, was the party line in today's hearing. And yet as the taxpayers' tab continues to mount, after multiple rounds of capital injection, extraordinary funding facilities, and last week's unveiling of the Fed's nuclear option, debt monetization, we have no further understanding of our financial saviors' analysis than a platitude about risk and catastrophe. For this we have unleashed trillions.
Surely, we the people deserve grittier stuff than that. Its our dime. It's pithy, sure, but m* wants to know where are the Powerpoint slides? Where are the charts? Surely there is a scratch-pad someplace with AIG's off balance sheet liabilities and the potential losses a potential bankruptcy might have entailed? A meeting agenda, a presentation, a back of an envelope?
Or have these gentlemen from the Fed, and now Treasury, led us down a course of treatment, founded on no more than a fear of an uncertain and painful future, that risks transforming our financial corpus beyond all recognition? If the analysis is correct, and the course of action appropriate, what is there to hide? Gentlemen, the envelope please.
Showing posts with label Money. Show all posts
Showing posts with label Money. Show all posts
Tuesday, March 24, 2009
Wednesday, September 19, 2007
Put, on.
It has been a one-two punch for moral hazard this week as the UK Treasury pressured the BOE into backstopping the reckless business practice of the media savvy managers of a third tier UK mortgage lender (a deposit taking hedge fund in any analysis) and the Bernanke Fed, after much ado about nothing socialized the equity markets with a put very generously struck at all time highs.
Global strategists are now calling for the mother of all rallies into next year as the rate cycle turns and growth projections for next year go from weighting recession probabilities to discounting that altogether more equity friendly concept "the mid-cycle slow down" whatever that is. US markets responded appropriately and Asian markets hyper-appropriately, while the dollar made new lows against most alternatives. Moral hazard indeed.
Whatever one calls it, the concept most on m*'s mind is not growth or hazard so much as store-of-value. As a long term dollar bear, m* has been living with a workable definition in a relative sense but the cave-in this week, though hardly surprising, is an eye-opening step towards the precipice. m* is forming the conviction, at something deeper than an intellectual level finally, that the idea in an absolute sense can not exist in our current (fiat) money world.
Comments?
Global strategists are now calling for the mother of all rallies into next year as the rate cycle turns and growth projections for next year go from weighting recession probabilities to discounting that altogether more equity friendly concept "the mid-cycle slow down" whatever that is. US markets responded appropriately and Asian markets hyper-appropriately, while the dollar made new lows against most alternatives. Moral hazard indeed.
Whatever one calls it, the concept most on m*'s mind is not growth or hazard so much as store-of-value. As a long term dollar bear, m* has been living with a workable definition in a relative sense but the cave-in this week, though hardly surprising, is an eye-opening step towards the precipice. m* is forming the conviction, at something deeper than an intellectual level finally, that the idea in an absolute sense can not exist in our current (fiat) money world.
Comments?
Thursday, September 13, 2007
Message from Mervyn
Yesterday, the argument for rate cuts to save the US from impending recessionary disaster of an unspecified nature was aired by it's most learned and esteemed advocate, Martin Feldstein, who repeated his narrowcast doom and gloom speech from the recent Jackson Hole conference in the mass market pages of the WSJ.
m* strongly disagreed with this view and held out the example of BOE's Mervyn King as a counterweight to the luminaries calling for easing. In typical fashion, King's voice during this period has thus far been conspicuous by it's absence, until today when King broke the silence with his first comments weeks into the current crisis in the money markets and structured debt markets. In a statement prepared for regularly scheduled testimony to the Treasury next week, King sends an eloquent, reasoned message to the markets about the hazards of short term, emotionally driven thinking and the responsibility of a central banker. The short of it is captured by headline-of-the-day award winner and frequent source Macro Man with "No Soup for You!"
TURMOIL IN FINANCIAL MARKETS: WHAT CAN CENTRAL BANKS DO?
Paper submitted to the Treasury Committee
Mervyn King, Governor of the Bank of England
The recent turmoil in financial markets has increased uncertainty in the world economy.
Problems that surfaced first in the US sub-prime mortgage market are now visible more
widely. All those involved, whether banks, other financial institutions, regulators or
central banks, need to analyse carefully the causes of the recent turmoil and think through
the long-term consequences of any actions if they are to respond appropriately.
So in this note I shall try to answer two questions. First, what are the immediate causes
of the recent turmoil and what are its implications? Second, what can and should central
banks do to alleviate the problems? In due course we shall all have time for a more
detailed examination of this episode and the lessons to be learned from it.
1. What are the immediate causes of the recent turmoil and what are its implications?
Since the beginning of August, there have been sharp movements in financial markets:
prices of loans, and assets backed by loans, have fallen; prices of government securities
have risen; and interest rates on inter-bank lending have risen.
Rising default rates on sub-prime mortgages in the United States were the trigger for the
recent financial market turmoil. It is important, though, to put recent events in
perspective. The world economy has been strong for the past five years. Our own
economy has been growing at a steady rate for a considerable period. There are major
problems in the US housing market to which the authorities there are responding with
both macro and micro measures. But the losses from defaults so far remain small relative
to the capital of the banking system.
None of this is meant to say we should be complacent. But the source of the problems
lies not in the state of the world economy, but in a mis-pricing of risk in the financial
system. And it is on that set of issues that we need to focus to determine the remedies,
both short-term to address the current problems and long-term to prevent a recurrence.
Why have developments in one part of the US mortgage market proved so important for a
wide range of financial markets? Sub-prime mortgages are one type of loan that banks
have parcelled together into securities backed by the cash flows from those loans – a
process known as securitisation. Those securities have been sold by banks to investors.
They have also been sold to investment vehicles, many of which have been established
by the banks themselves. Many of these vehicles have financed their purchases by
issuing short-term commercial paper.
Securitisation of loans has separated the information held by loan originators from those
exposed to the risk of default – investors in asset-backed securities or commercial paper.
The unexpected losses sustained on assets backed by US sub-prime mortgages have
highlighted the potential costs to investors of uncertainty about the types of loans
underlying the assets they purchase. So for the time being the markets in these
instruments have either closed or become very illiquid. Vehicles financed by short-term
commercial paper are holding assets which can no longer be traded in liquid markets.
They now find that they have borrowed short to lend long – normally thought of as a
function of banks.
As a result of this maturity mismatch, vehicles set up by banks and others are now
finding it extremely difficult to obtain funding through asset-backed commercial paper.
The markets are now withdrawing short-term funding from such vehicles, a process not
unlike a bank run. Many investment vehicles have been forced to shorten the maturity of
their commercial paper, making their borrowing even more short-term and their maturity
mismatch even greater. Other vehicles have been unable to issue at all. For example,
since the beginning of August the value of asset backed commercial paper outstanding in
the US has fallen by almost 20%.
Some investment vehicles will need to be wound up. In many cases, however, the
sponsoring bank will have written a backup line to the vehicle, guaranteeing its funding.
Many of the securitised loans may now be re-priced, restructured or taken back by the
banks. A process is starting that will expand the balance sheet of the banking system.
But how far that process will go is hard to tell.
The vehicles can be taken back onto banks’ balance sheets. Banks as a whole are well
capitalised and should be able to do this. Moreover, the funds that were directed to assetbacked securities and commercial paper will now be available elsewhere. In the end, that funding will come back to the banking system, although between banks the distribution
will differ. So the adjustment period may be awkward and, during it, banks are placing a
premium on holding assets which can quickly be turned into cash.
The increase in demand for liquid assets during the adjustment period is one reason why,
in all the major economies, yields on liquid assets like government securities have fallen.
It also helps to explain why the compensation needed for banks to lend to other banks
over periods longer than overnight has risen and why the volume of inter-bank lending
has been increasingly concentrated at shorter maturities. Since the beginning of August,
the spread between interest rates for 3-month inter-bank lending and central bank interest
rates expected over that period has risen in all the major economies. At present, the
average spread is 110 basis points in sterling and 90 basis points in dollars. This is the
natural economic result of a change in the preferences of banks over the composition of
the assets they wish to hold on their balance sheets.
In addition, banks have raised their demand for reserves at central banks. Banks settle
payments with each other using central bank money and they hold reserves at the Bank of
England to manage their daily payment needs. Conditions in financial markets have
made their payment needs less predictable. As a result, banks have wanted to hold more
reserves. They have tried to fund those reserves by borrowing overnight from other
banks. Over the past month, interest rates on secured overnight borrowing have averaged
5.91% – 16 basis points above Bank Rate. That spread was wider than usual – since the
introduction of the current money market regime, it has averaged 3 basis points.
These changes in the distribution of assets across the financial sector, and banks’
preferences over different assets during the adjustment period, are likely to have
consequences for the wider economy through the interest rates for borrowing and lending
faced by households and companies. It is too soon, however, to quantify the impact on
the economy as a whole.
In the short term, some corporate loan rates will rise in line with inter-bank rates. Banks
that are unable to sell pools of loans that they had securitised, or who need to support offbalance sheet vehicles, may cut back on new lending. But banks whose potential funding
liabilities to vehicles or conduits are small as a proportion of their balance sheet may be
able to exploit profitable lending opportunities, which may not be as open to those banks
which are now hoarding liquidity. So there may be a redirection of borrowing from
within the banking system. This is part of a normal market adjustment.
Funds that had been invested in asset-backed commercial paper issued by vehicles and
conduits will find their way back to the financial system, perhaps directly through bank
deposits or indirectly via the corporate sector by purchases of corporate debt. It is
notable that yields on investment-grade corporate bonds are unchanged since the
beginning of August. And companies, including some financial institutions, have been
able to issue long-term debt.
Nevertheless, there has since mid-July been a widespread reassessment of the
compensation investors seek for bearing risk. Equity prices have fallen in all major
economies. Most of that adjustment took place in July – before the turmoil in credit
markets. The FTSE All-Share today is 6% below its level at the beginning of July. As
this re-pricing of risk passes through to borrowers, the supply of credit faced by
households and companies may tighten somewhat.
In summary, the turmoil in financial markets since the beginning of August stems from a
reluctance by investors to purchase financial instruments backed by loans. Liquidity in
asset-backed markets has dried up and a process of re-intermediation has begun, in which
banks move some way back towards their traditional role taking deposits and lending
them. That process is likely to be temporary but it may not be smooth. During that
process, demand for liquidity by the banking system has increased, leading to a
substantial rise in inter-bank rates.
2. What can and should central banks do to alleviate these problems?
Three distinct policy instruments can be deployed by central banks: interest rates, money
market operations, and other general liquidity support operations.
First, what role should monetary policy play in the present situation? The answer is to
protect the public from the consequences of the recent turmoil by continuing to maintain
economic stability. That is done by setting interest rates in order to meet the 2% target
for inflation. Interest rates are a flexible tool and can be adjusted quickly when
necessary. If, in the wake of a shock to the financial system, the terms on which the
financial system extends credit to the private sector become less favourable, then
borrowing and overall demand would weaken. Other things being equal, that would
lower the inflation outlook. Of course, other things are not equal. When the Monetary
Policy Committee meets each month it reviews all the evidence on the outlook on
inflation before reaching a judgment. The August Inflation Report implied that some
slowdown from recent strong rates of economic growth was needed to meet the inflation
target. The new element introduced by the recent turmoil is that effective borrowing
rates facing households and companies will rise somewhat. So, as we said in the August
Report, the Committee is monitoring credit conditions intensively. It is too soon to tell
how persistent and how large any change in credit conditions for household and corporate
borrowers will prove to be. A new Bank of England Credit Conditions Survey will be
available to the MPC at its next meeting.
Second, the central bank is responsible for the smooth functioning of the payment system
among banks – the short-term money markets and what is known as the high value
payment system. Central banks discharge that responsibility by providing reserves that
enable banks to settle among themselves. In the reform of our money market operations
a year ago, we made very clear, and this is a unique feature of the British system, that the
banking system as a whole will get the reserves that it itself requests. Each month, at the
beginning of what is known as the maintenance period, running from one MPC meeting
to the next, banks set their own reserve targets. They are not imposed. We then supply
the reserves that the banking system as a whole requests. The objective is to allow banks
to deal with their own day-to-day liquidity needs and, by supplying in aggregate the
banks’ demand for reserves, to keep the overnight interest rate close to Bank Rate set by
the Monetary Policy Committee. If any individual bank has misjudged its reserves target
and finds that on any day, due to unusually large payment flows, it needs additional
liquidity, then that is supplied against eligible collateral at a penalty rate. There is
automatic and guaranteed access to the standing facility in return for eligible collateral
and a penalty rate of 1% above Bank Rate. It should be clear that because standing
facilities are available at the borrower’s discretion and against eligible collateral, they are
quite distinct from what is known in other financial centres as “emergency liquidity
assistance”, and under the UK tripartite framework as lender of last resort arrangements,
where the central bank decides that there is a policy objective in lending to one or more
institutions. Reflecting these different aims, the collateral required is different.
The interest rate for secured overnight borrowing was, in August, unusually high relative
to Bank Rate, indicating that banks’ aggregate demand for central bank reserves had risen
since they set their reserves targets. For the current maintenance period, which began on
6 September, the reserves banks raised their target levels of reserves by 6%. That larger
quantity of reserves was supplied by the Bank of England in its open market operation on
6 September.
As expected, some pressure on interest rates for overnight borrowing was relieved. Last
week, we announced that, during the current maintenance period, we will make available
to banks additional reserves, up to 25% of the reserves target, if the secured overnight
rate remains higher than usual relative to Bank Rate. The reason for this is that there are
grounds for suspecting that banks may, at the start of the current maintenance period,
have underestimated their demand for reserves, and the additional reserves will help to
bring the overnight rate into line with Bank Rate. We will announce the terms of this
week’s operation on Thursday. Provision of central bank reserves, in exchange for highquality
collateral, cannot be expected to narrow the spreads between anticipated policy
rates and the rates at which commercial banks can borrow from each other at longer
maturities, and has not done so elsewhere.
So, third, is there a case for the provision of additional central bank liquidity against a
wider range of collateral and over longer periods in order to reduce market interest rates
at longer maturities? This is the most difficult issue facing central banks at present and
requires a balancing act between two different considerations. On the one hand, the
provision of greater short-term liquidity against illiquid collateral might ease the process
of taking the assets of vehicles back onto bank balance sheets and so reduce term market
interest rates. But, on the other hand, the provision of such liquidity support undermines
the efficient pricing of risk by providing ex post insurance for risky behaviour. That
encourages excessive risk-taking, and sows the seeds of a future financial crisis. So
central banks cannot sensibly entertain such operations merely to restore the status quo
ante. Rather, there must be strong grounds for believing that the absence of ex post
insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in
the future. In this event, such operations would seek to ensure that the financial system
continues to function effectively.
As we move along a difficult adjustment path there are three reasons for being careful
about where to tread. First, the hoarding of liquidity is a finite process. When any
transfers of the assets of vehicles back onto banks’ balance sheets are complete, the
demand for additional liquidity, and the associated rise in LIBOR spreads, will fall back.
The fragility of sentiment at present means that the system is vulnerable to further shocks
and it is important to monitor financial conditions extremely closely. But the banking
system as a whole is strong enough to withstand the impact of taking onto the balance
sheet the assets of conduits and other vehicles.
Second, the private sector will gradually re-establish valuations of most asset backed
securities, thus allowing liquidity in those markets to build up. Indeed, there are market
incentives to speed up the process both of taking assets back onto balance sheets and to
re-open markets in securities that have closed. Already there are tentative steps in this
direction which will allow the price discovery process to restart. Strong institutions have
incentives to reveal their positions to obtain better access to funding. Some are tapping
long-term paper. And there are opportunities to make money for those who can assess
and value instruments and eventually repackage and reissue them. Difficult and timeconsuming though that process may be, it will also slowly reduce that part of the rise in
market rates which reflects counterparty risk.
Third, the moral hazard inherent in the provision of ex post insurance to institutions that
have engaged in risky or reckless lending is no abstract concept. The risks of the
potential maturity transformation undertaken by off-balance sheet vehicles were not fully
priced. The increase in maturity transformation implied by a change in the effective
liquidity in the markets for asset-backed securities was identified as a risk by a wide
range of official publications, including the Bank of England’s Financial Stability
Report, over several years. If central banks underwrite any maturity transformation that
threatens to damage the economy as a whole, it encourages the view that as long as a
bank takes the same sort of risks that other banks are taking then it is more likely that
their liquidity problems will be insured ex post by the central bank. The provision of
large liquidity facilities penalises those financial institutions that sat out the dance,
encourages herd behaviour and increases the intensity of future crises.
In addition, central banks, in their traditional lender of last resort (LOLR) role, can lend
“against good collateral at a penalty rate” to an individual bank facing temporary
liquidity problems, but that is otherwise regarded as solvent. The rationale would be that
the failure of such a bank would lead to serious economic damage, including to the
customers of the bank. The moral hazard of an increase in risk-taking resulting from the
provision of LOLR lending is reduced by making liquidity available only at a penalty
rate. Such operations in this country are covered by the tripartite arrangements set out in
the MOU between the Treasury, Financial Services Authority and the Bank of England.
Because they are made to individual institutions, they are flexible with respect to type of
collateral and term of the facility. LOLR operations remain in the armoury of all central
banks.
Conclusions
The path ahead is uncertain. There are strong private incentives to market players to
recognise early and transparently their exposures to off-balance sheet entities and to
accelerate the re-pricing of asset-backed securities. Policy actions must be supportive of
this process. Injections of liquidity in normal money market operations against high
quality collateral are unlikely by themselves to bring down the LIBOR spreads that
reflect a need for banks collectively to finance the expansion of their balance sheets. To
do that, general injections of liquidity against a wider range of collateral would be
necessary. But unless they were made available at an appropriate penalty rate, they
would encourage in future the very risk-taking that has led us to where we are. All
central banks are aware that there are circumstances in which action might be necessary
to prevent a major shock to the system as a whole. Balancing these considerations will
pose considerable challenges, and in present circumstances judging that balance is
something we do almost daily.
The key objectives remain, first, the continuous pursuit of the inflation target to maintain
economic stability and, second, ensuring that the financial system continues to function
effectively, including the proper pricing of risk. If risk continues to be under-priced, the
next period of turmoil will be on an even bigger scale. The current turmoil, which has at
its heart the earlier under-pricing of risk, has disturbed the unusual serenity of recent
years, but, managed properly, it should not threaten our long-run economic stability.
m* strongly disagreed with this view and held out the example of BOE's Mervyn King as a counterweight to the luminaries calling for easing. In typical fashion, King's voice during this period has thus far been conspicuous by it's absence, until today when King broke the silence with his first comments weeks into the current crisis in the money markets and structured debt markets. In a statement prepared for regularly scheduled testimony to the Treasury next week, King sends an eloquent, reasoned message to the markets about the hazards of short term, emotionally driven thinking and the responsibility of a central banker. The short of it is captured by headline-of-the-day award winner and frequent source Macro Man with "No Soup for You!"
TURMOIL IN FINANCIAL MARKETS: WHAT CAN CENTRAL BANKS DO?
Paper submitted to the Treasury Committee
Mervyn King, Governor of the Bank of England
The recent turmoil in financial markets has increased uncertainty in the world economy.
Problems that surfaced first in the US sub-prime mortgage market are now visible more
widely. All those involved, whether banks, other financial institutions, regulators or
central banks, need to analyse carefully the causes of the recent turmoil and think through
the long-term consequences of any actions if they are to respond appropriately.
So in this note I shall try to answer two questions. First, what are the immediate causes
of the recent turmoil and what are its implications? Second, what can and should central
banks do to alleviate the problems? In due course we shall all have time for a more
detailed examination of this episode and the lessons to be learned from it.
1. What are the immediate causes of the recent turmoil and what are its implications?
Since the beginning of August, there have been sharp movements in financial markets:
prices of loans, and assets backed by loans, have fallen; prices of government securities
have risen; and interest rates on inter-bank lending have risen.
Rising default rates on sub-prime mortgages in the United States were the trigger for the
recent financial market turmoil. It is important, though, to put recent events in
perspective. The world economy has been strong for the past five years. Our own
economy has been growing at a steady rate for a considerable period. There are major
problems in the US housing market to which the authorities there are responding with
both macro and micro measures. But the losses from defaults so far remain small relative
to the capital of the banking system.
None of this is meant to say we should be complacent. But the source of the problems
lies not in the state of the world economy, but in a mis-pricing of risk in the financial
system. And it is on that set of issues that we need to focus to determine the remedies,
both short-term to address the current problems and long-term to prevent a recurrence.
Why have developments in one part of the US mortgage market proved so important for a
wide range of financial markets? Sub-prime mortgages are one type of loan that banks
have parcelled together into securities backed by the cash flows from those loans – a
process known as securitisation. Those securities have been sold by banks to investors.
They have also been sold to investment vehicles, many of which have been established
by the banks themselves. Many of these vehicles have financed their purchases by
issuing short-term commercial paper.
Securitisation of loans has separated the information held by loan originators from those
exposed to the risk of default – investors in asset-backed securities or commercial paper.
The unexpected losses sustained on assets backed by US sub-prime mortgages have
highlighted the potential costs to investors of uncertainty about the types of loans
underlying the assets they purchase. So for the time being the markets in these
instruments have either closed or become very illiquid. Vehicles financed by short-term
commercial paper are holding assets which can no longer be traded in liquid markets.
They now find that they have borrowed short to lend long – normally thought of as a
function of banks.
As a result of this maturity mismatch, vehicles set up by banks and others are now
finding it extremely difficult to obtain funding through asset-backed commercial paper.
The markets are now withdrawing short-term funding from such vehicles, a process not
unlike a bank run. Many investment vehicles have been forced to shorten the maturity of
their commercial paper, making their borrowing even more short-term and their maturity
mismatch even greater. Other vehicles have been unable to issue at all. For example,
since the beginning of August the value of asset backed commercial paper outstanding in
the US has fallen by almost 20%.
Some investment vehicles will need to be wound up. In many cases, however, the
sponsoring bank will have written a backup line to the vehicle, guaranteeing its funding.
Many of the securitised loans may now be re-priced, restructured or taken back by the
banks. A process is starting that will expand the balance sheet of the banking system.
But how far that process will go is hard to tell.
The vehicles can be taken back onto banks’ balance sheets. Banks as a whole are well
capitalised and should be able to do this. Moreover, the funds that were directed to assetbacked securities and commercial paper will now be available elsewhere. In the end, that funding will come back to the banking system, although between banks the distribution
will differ. So the adjustment period may be awkward and, during it, banks are placing a
premium on holding assets which can quickly be turned into cash.
The increase in demand for liquid assets during the adjustment period is one reason why,
in all the major economies, yields on liquid assets like government securities have fallen.
It also helps to explain why the compensation needed for banks to lend to other banks
over periods longer than overnight has risen and why the volume of inter-bank lending
has been increasingly concentrated at shorter maturities. Since the beginning of August,
the spread between interest rates for 3-month inter-bank lending and central bank interest
rates expected over that period has risen in all the major economies. At present, the
average spread is 110 basis points in sterling and 90 basis points in dollars. This is the
natural economic result of a change in the preferences of banks over the composition of
the assets they wish to hold on their balance sheets.
In addition, banks have raised their demand for reserves at central banks. Banks settle
payments with each other using central bank money and they hold reserves at the Bank of
England to manage their daily payment needs. Conditions in financial markets have
made their payment needs less predictable. As a result, banks have wanted to hold more
reserves. They have tried to fund those reserves by borrowing overnight from other
banks. Over the past month, interest rates on secured overnight borrowing have averaged
5.91% – 16 basis points above Bank Rate. That spread was wider than usual – since the
introduction of the current money market regime, it has averaged 3 basis points.
These changes in the distribution of assets across the financial sector, and banks’
preferences over different assets during the adjustment period, are likely to have
consequences for the wider economy through the interest rates for borrowing and lending
faced by households and companies. It is too soon, however, to quantify the impact on
the economy as a whole.
In the short term, some corporate loan rates will rise in line with inter-bank rates. Banks
that are unable to sell pools of loans that they had securitised, or who need to support offbalance sheet vehicles, may cut back on new lending. But banks whose potential funding
liabilities to vehicles or conduits are small as a proportion of their balance sheet may be
able to exploit profitable lending opportunities, which may not be as open to those banks
which are now hoarding liquidity. So there may be a redirection of borrowing from
within the banking system. This is part of a normal market adjustment.
Funds that had been invested in asset-backed commercial paper issued by vehicles and
conduits will find their way back to the financial system, perhaps directly through bank
deposits or indirectly via the corporate sector by purchases of corporate debt. It is
notable that yields on investment-grade corporate bonds are unchanged since the
beginning of August. And companies, including some financial institutions, have been
able to issue long-term debt.
Nevertheless, there has since mid-July been a widespread reassessment of the
compensation investors seek for bearing risk. Equity prices have fallen in all major
economies. Most of that adjustment took place in July – before the turmoil in credit
markets. The FTSE All-Share today is 6% below its level at the beginning of July. As
this re-pricing of risk passes through to borrowers, the supply of credit faced by
households and companies may tighten somewhat.
In summary, the turmoil in financial markets since the beginning of August stems from a
reluctance by investors to purchase financial instruments backed by loans. Liquidity in
asset-backed markets has dried up and a process of re-intermediation has begun, in which
banks move some way back towards their traditional role taking deposits and lending
them. That process is likely to be temporary but it may not be smooth. During that
process, demand for liquidity by the banking system has increased, leading to a
substantial rise in inter-bank rates.
2. What can and should central banks do to alleviate these problems?
Three distinct policy instruments can be deployed by central banks: interest rates, money
market operations, and other general liquidity support operations.
First, what role should monetary policy play in the present situation? The answer is to
protect the public from the consequences of the recent turmoil by continuing to maintain
economic stability. That is done by setting interest rates in order to meet the 2% target
for inflation. Interest rates are a flexible tool and can be adjusted quickly when
necessary. If, in the wake of a shock to the financial system, the terms on which the
financial system extends credit to the private sector become less favourable, then
borrowing and overall demand would weaken. Other things being equal, that would
lower the inflation outlook. Of course, other things are not equal. When the Monetary
Policy Committee meets each month it reviews all the evidence on the outlook on
inflation before reaching a judgment. The August Inflation Report implied that some
slowdown from recent strong rates of economic growth was needed to meet the inflation
target. The new element introduced by the recent turmoil is that effective borrowing
rates facing households and companies will rise somewhat. So, as we said in the August
Report, the Committee is monitoring credit conditions intensively. It is too soon to tell
how persistent and how large any change in credit conditions for household and corporate
borrowers will prove to be. A new Bank of England Credit Conditions Survey will be
available to the MPC at its next meeting.
Second, the central bank is responsible for the smooth functioning of the payment system
among banks – the short-term money markets and what is known as the high value
payment system. Central banks discharge that responsibility by providing reserves that
enable banks to settle among themselves. In the reform of our money market operations
a year ago, we made very clear, and this is a unique feature of the British system, that the
banking system as a whole will get the reserves that it itself requests. Each month, at the
beginning of what is known as the maintenance period, running from one MPC meeting
to the next, banks set their own reserve targets. They are not imposed. We then supply
the reserves that the banking system as a whole requests. The objective is to allow banks
to deal with their own day-to-day liquidity needs and, by supplying in aggregate the
banks’ demand for reserves, to keep the overnight interest rate close to Bank Rate set by
the Monetary Policy Committee. If any individual bank has misjudged its reserves target
and finds that on any day, due to unusually large payment flows, it needs additional
liquidity, then that is supplied against eligible collateral at a penalty rate. There is
automatic and guaranteed access to the standing facility in return for eligible collateral
and a penalty rate of 1% above Bank Rate. It should be clear that because standing
facilities are available at the borrower’s discretion and against eligible collateral, they are
quite distinct from what is known in other financial centres as “emergency liquidity
assistance”, and under the UK tripartite framework as lender of last resort arrangements,
where the central bank decides that there is a policy objective in lending to one or more
institutions. Reflecting these different aims, the collateral required is different.
The interest rate for secured overnight borrowing was, in August, unusually high relative
to Bank Rate, indicating that banks’ aggregate demand for central bank reserves had risen
since they set their reserves targets. For the current maintenance period, which began on
6 September, the reserves banks raised their target levels of reserves by 6%. That larger
quantity of reserves was supplied by the Bank of England in its open market operation on
6 September.
As expected, some pressure on interest rates for overnight borrowing was relieved. Last
week, we announced that, during the current maintenance period, we will make available
to banks additional reserves, up to 25% of the reserves target, if the secured overnight
rate remains higher than usual relative to Bank Rate. The reason for this is that there are
grounds for suspecting that banks may, at the start of the current maintenance period,
have underestimated their demand for reserves, and the additional reserves will help to
bring the overnight rate into line with Bank Rate. We will announce the terms of this
week’s operation on Thursday. Provision of central bank reserves, in exchange for highquality
collateral, cannot be expected to narrow the spreads between anticipated policy
rates and the rates at which commercial banks can borrow from each other at longer
maturities, and has not done so elsewhere.
So, third, is there a case for the provision of additional central bank liquidity against a
wider range of collateral and over longer periods in order to reduce market interest rates
at longer maturities? This is the most difficult issue facing central banks at present and
requires a balancing act between two different considerations. On the one hand, the
provision of greater short-term liquidity against illiquid collateral might ease the process
of taking the assets of vehicles back onto bank balance sheets and so reduce term market
interest rates. But, on the other hand, the provision of such liquidity support undermines
the efficient pricing of risk by providing ex post insurance for risky behaviour. That
encourages excessive risk-taking, and sows the seeds of a future financial crisis. So
central banks cannot sensibly entertain such operations merely to restore the status quo
ante. Rather, there must be strong grounds for believing that the absence of ex post
insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in
the future. In this event, such operations would seek to ensure that the financial system
continues to function effectively.
As we move along a difficult adjustment path there are three reasons for being careful
about where to tread. First, the hoarding of liquidity is a finite process. When any
transfers of the assets of vehicles back onto banks’ balance sheets are complete, the
demand for additional liquidity, and the associated rise in LIBOR spreads, will fall back.
The fragility of sentiment at present means that the system is vulnerable to further shocks
and it is important to monitor financial conditions extremely closely. But the banking
system as a whole is strong enough to withstand the impact of taking onto the balance
sheet the assets of conduits and other vehicles.
Second, the private sector will gradually re-establish valuations of most asset backed
securities, thus allowing liquidity in those markets to build up. Indeed, there are market
incentives to speed up the process both of taking assets back onto balance sheets and to
re-open markets in securities that have closed. Already there are tentative steps in this
direction which will allow the price discovery process to restart. Strong institutions have
incentives to reveal their positions to obtain better access to funding. Some are tapping
long-term paper. And there are opportunities to make money for those who can assess
and value instruments and eventually repackage and reissue them. Difficult and timeconsuming though that process may be, it will also slowly reduce that part of the rise in
market rates which reflects counterparty risk.
Third, the moral hazard inherent in the provision of ex post insurance to institutions that
have engaged in risky or reckless lending is no abstract concept. The risks of the
potential maturity transformation undertaken by off-balance sheet vehicles were not fully
priced. The increase in maturity transformation implied by a change in the effective
liquidity in the markets for asset-backed securities was identified as a risk by a wide
range of official publications, including the Bank of England’s Financial Stability
Report, over several years. If central banks underwrite any maturity transformation that
threatens to damage the economy as a whole, it encourages the view that as long as a
bank takes the same sort of risks that other banks are taking then it is more likely that
their liquidity problems will be insured ex post by the central bank. The provision of
large liquidity facilities penalises those financial institutions that sat out the dance,
encourages herd behaviour and increases the intensity of future crises.
In addition, central banks, in their traditional lender of last resort (LOLR) role, can lend
“against good collateral at a penalty rate” to an individual bank facing temporary
liquidity problems, but that is otherwise regarded as solvent. The rationale would be that
the failure of such a bank would lead to serious economic damage, including to the
customers of the bank. The moral hazard of an increase in risk-taking resulting from the
provision of LOLR lending is reduced by making liquidity available only at a penalty
rate. Such operations in this country are covered by the tripartite arrangements set out in
the MOU between the Treasury, Financial Services Authority and the Bank of England.
Because they are made to individual institutions, they are flexible with respect to type of
collateral and term of the facility. LOLR operations remain in the armoury of all central
banks.
Conclusions
The path ahead is uncertain. There are strong private incentives to market players to
recognise early and transparently their exposures to off-balance sheet entities and to
accelerate the re-pricing of asset-backed securities. Policy actions must be supportive of
this process. Injections of liquidity in normal money market operations against high
quality collateral are unlikely by themselves to bring down the LIBOR spreads that
reflect a need for banks collectively to finance the expansion of their balance sheets. To
do that, general injections of liquidity against a wider range of collateral would be
necessary. But unless they were made available at an appropriate penalty rate, they
would encourage in future the very risk-taking that has led us to where we are. All
central banks are aware that there are circumstances in which action might be necessary
to prevent a major shock to the system as a whole. Balancing these considerations will
pose considerable challenges, and in present circumstances judging that balance is
something we do almost daily.
The key objectives remain, first, the continuous pursuit of the inflation target to maintain
economic stability and, second, ensuring that the financial system continues to function
effectively, including the proper pricing of risk. If risk continues to be under-priced, the
next period of turmoil will be on an even bigger scale. The current turmoil, which has at
its heart the earlier under-pricing of risk, has disturbed the unusual serenity of recent
years, but, managed properly, it should not threaten our long-run economic stability.
Wednesday, September 12, 2007
"Liquidity Now!"
m* finally got around to Chris Giles' FT puff piece on Mervyn King, who is, as m* readers are well aware, the indomitable head of the BOE, a Villa fan, and a man for our times, monetarily speaking. It was timely because King and the BOE are standing pretty much alone with the view that there really is not much to be done for the problems in the credit markets (a view m* shared back here).
With the ECB across the channel shoveling as fast as it can (another $100bn this week), and the Fed across the pond kowtowing left and right, to mere Congressmen even, the dependency bred of the mommy(daddy?) state is threatening to turn ugly. It is taken on faith that the Fed can be counted on to handle any and all economic and financial problems the rest of us may collectively create (even with just the one or two blunt instruments they possess).
This is fairly depressing, psychologically and monetarily, as the dollar continues to sink against the major competitors (and gold continues to rise) just as certain skeptics and farsighted analysts predicted in 2003, while shorting 10's (at 3.5%) and the dollar against all comers. Fortunately for the moralists and those who travel with them, there is King, taking the heat, speaking truth to power (ok, maybe a bit much,) and holding firm for the reality based squad. It is getting tough though as the critics are starting to threaten him with history already, a la W.
For a view of what he is up against, look no further than today's WSJ Op-Ed piece by Martin Feldstein. The prominent economist's demand for "Liquidity Now" though it admittedly "cannot solve the credit market problems" would, in his opinion "help the economy: by stimulating demand for housing, autos, durables; by encouraging a more competitive dollar to stimulate increased net exports; by raising share prices to increase both business investment and consumer spending; and by freeing up spendable cash for homeowners with adjustable rate mortgages."
While that sounds just dandy, a textbook platform for election, with apparently no more consequences than another ratchet up in inflation that can always! be dealt with at a later and more convenient time, one has to wonder which planet Mr. Feldstein has spent the early part of the 21st century on? Why not dispense with all the transmission friction and just print money?
Is there yet more unsatisfied demand for autos and trucks and houses and washing machines than m* understands? Perhaps, if at some point in time the monthly financing of those items were to approach what Prof. Feldstein might argue a more reasonable level (free ?).
Prof. Feldstein seems to believe in a kind of perpetual economic motion machine, where a bit sand gets in the gears and the Fed can oil our way out from time to time. He seems to think that consumption fueled by debt is not the spending of future income today, that it can go on at the same pace, this most recent torrid pace, for ever. And whatever unfortunate circumstances bring about a slowdown in that pace, a recession in other words, is something to be avoided certainly, but that also always can be avoided, completely apart from the conditions that might have caused it to arise in the first place.
m* takes strong umbrage with this view. The Fed is not stepping on a gas pedal or pulling up on a brake on an economic car following a linear road of progress, as is often commonly imagined and former Chairman Greenspan's metaphor described. It is instead adjusting the size of the drag-chute on a one way natural proclivity to spend tomorrow's income today.
As Gerard Minack at Morgan Stanley highlighted today, the "Japanese problem" so feared at policy levels is often portrayed as one of (exogenous?) deflation depressing animal spirits. The real issue is deleveraging. Then, as now, the natural proclivity to borrow from the future ran until it exhausted the ability of current income to sustain it.
But "Liquidity Now!" is an argument against gravity, one more contribution to the literature of faith based reality. And Prof. Feldstein has no compunction about wishing to continue borrowing from the future, rewarding spenders over savers, and tearing asunder the heavily tattered fabric of civilized society's foundation on delayed gratification and rewards for work. Why?
With the ECB across the channel shoveling as fast as it can (another $100bn this week), and the Fed across the pond kowtowing left and right, to mere Congressmen even, the dependency bred of the mommy(daddy?) state is threatening to turn ugly. It is taken on faith that the Fed can be counted on to handle any and all economic and financial problems the rest of us may collectively create (even with just the one or two blunt instruments they possess).
This is fairly depressing, psychologically and monetarily, as the dollar continues to sink against the major competitors (and gold continues to rise) just as certain skeptics and farsighted analysts predicted in 2003, while shorting 10's (at 3.5%) and the dollar against all comers. Fortunately for the moralists and those who travel with them, there is King, taking the heat, speaking truth to power (ok, maybe a bit much,) and holding firm for the reality based squad. It is getting tough though as the critics are starting to threaten him with history already, a la W.
For a view of what he is up against, look no further than today's WSJ Op-Ed piece by Martin Feldstein. The prominent economist's demand for "Liquidity Now" though it admittedly "cannot solve the credit market problems" would, in his opinion "help the economy: by stimulating demand for housing, autos, durables; by encouraging a more competitive dollar to stimulate increased net exports; by raising share prices to increase both business investment and consumer spending; and by freeing up spendable cash for homeowners with adjustable rate mortgages."
While that sounds just dandy, a textbook platform for election, with apparently no more consequences than another ratchet up in inflation that can always! be dealt with at a later and more convenient time, one has to wonder which planet Mr. Feldstein has spent the early part of the 21st century on? Why not dispense with all the transmission friction and just print money?
Is there yet more unsatisfied demand for autos and trucks and houses and washing machines than m* understands? Perhaps, if at some point in time the monthly financing of those items were to approach what Prof. Feldstein might argue a more reasonable level (free ?).
Prof. Feldstein seems to believe in a kind of perpetual economic motion machine, where a bit sand gets in the gears and the Fed can oil our way out from time to time. He seems to think that consumption fueled by debt is not the spending of future income today, that it can go on at the same pace, this most recent torrid pace, for ever. And whatever unfortunate circumstances bring about a slowdown in that pace, a recession in other words, is something to be avoided certainly, but that also always can be avoided, completely apart from the conditions that might have caused it to arise in the first place.
m* takes strong umbrage with this view. The Fed is not stepping on a gas pedal or pulling up on a brake on an economic car following a linear road of progress, as is often commonly imagined and former Chairman Greenspan's metaphor described. It is instead adjusting the size of the drag-chute on a one way natural proclivity to spend tomorrow's income today.
As Gerard Minack at Morgan Stanley highlighted today, the "Japanese problem" so feared at policy levels is often portrayed as one of (exogenous?) deflation depressing animal spirits. The real issue is deleveraging. Then, as now, the natural proclivity to borrow from the future ran until it exhausted the ability of current income to sustain it.
But "Liquidity Now!" is an argument against gravity, one more contribution to the literature of faith based reality. And Prof. Feldstein has no compunction about wishing to continue borrowing from the future, rewarding spenders over savers, and tearing asunder the heavily tattered fabric of civilized society's foundation on delayed gratification and rewards for work. Why?
Thursday, September 6, 2007
Now or later
Placing their shared public bias towards higher rates on hold the BOE and ECB both took no action on rates at their regular meetings today, dutifully paying lip service as well as further billions in taxpayers' money (through the inflation tax), to the delicate nature of current conditions. Gold is breaking out above $700, having rallied 10% from the low of early July, and m* has to say that makes a lot of sense, while Hong Kong's Hang Seng index, also a beneficiary of abundant liquidity, sits at 24,000, up 40% on the year in local terms.
In the "Now" column, yesterday's Fed Beige Book survey of regional economies showed little thus far in the way of impact beyond housing construction and financing from the current crunch in, uh, housing construction and financing. Atlanta Fed Governor Lockhart commented, "So far, I have not seen hard or soft data that provide conclusive signs that housing problems are spilling over into the broad economy..." And, "I would like to see inflation sustained at a somewhat lower rate -- with emphasis on `sustained.' If inflation is allowed to accelerate, bringing it back down will be costly and painful..."
Governor Lockhart is a non-voting member until 2009 and so faces less public pressure than others, or the ECB today for example, but one would think he has a pretty good vantage point on the economy in overdeveloped Atlanta. Is it possible Toll Brothers management does not have Lockhart's phone number?
Nonetheless, with equity markets having already baked in at least 25bp from the Fed for Sep 18th, the probability of the Fed coming up with anything less (thereby disappointing a technically irrelevant constituency that happens however to pull the levers of public opinion) has to be seen as very small.
Yet despite the seeming inevitability of something the Fed's maneuvers thus far demonstrate its great reluctance to do, the debate (excellent summary today by the FT's Krishna Guha) as to whether a rate cut will actually do anything for the animal spirits of the abcp market or consumer confidence comes down fairly clearly against in m*'s mind.
In the "later" column, where recession fears are getting a pretty good airing at the expense of inflation fears (and moralists moralizing on the morals of bailouts, credit bubbles, and profligate Central Banks etc.) a few prominent economists are starting to gather. Chief among them is Martin Feldstein, of Harvard, NBER, and high off the last word at the Jackson Hole confab last weekend, where he said the possibility of a recession, based on what is happening in home construction and home finance, may be strong enough for an anticipatory response now from policymakers even at the expense of higher inflation "later."
m* says, what's the rush?
Look at the problems in the market transmission mechanism. Are rate cuts going to bring transparency to bank's off-balance sheet financing of the asset backed commercial paper market (a trust problem)? Are they going to do much to stabilize bids in credit markets for structured home-finance paper of heretofore rated but now unknown quality (an information problem)? Will they do much for the dozens of bankrupt mortgage originators, levered speculative funds, and ill-informed, ignorant, or just greedy investors with losses (an insolvency problem)?
Look at the problem in the housing market transmission mechanism. Home builders and speculators created an excess supply of housing. Are rate cuts going to speed the absorption of houses on the market to the point where builders will have reason to build more? Are rate cuts going to bring back appreciating prices enabling the MEW for consumption cycle to start again?
No. Time may be money, but money is not time. These problems need time.
Rate cuts now will make it easier for banks to hold onto, or demand higher prices for, the $250bn pipeline of deal debt committed to (should policy seek to socialize the swallowing of that bubble). Will that help bring down interbank lending rates? Sure. But vulture investors seeking to relieve banks of this burden are eyeballing double digit returns - levered of course. Is that a cry for help, now?
Rate cuts now will lower the discount rate for equities, making headlines and boosting morale, particularly for the classes with no exposure to equities, but they are unlikely to enjoy renewed access to sub-prime credit as a result. Rate cuts will lower the cost of capital for prime borrowers, perhaps, but prime borrowers do not seem to be suffering at this point.
If things are going to be as bad as the fearful fear, rates are going to have to go low enough to start the bubble machine again. There is plenty of time for that, (remember those monetary policy lags too!). The Fed has done enough, and through it's liquidity injections, is doing enough, for now. Give it time.
If m* is looking for justice, and there may be just a little of it corrupting the analysis today, at least the short squeeze in Countrywide is now definitively done. Sorry BoA. Maybe $18 should have been the "bail in" price!
In the "Now" column, yesterday's Fed Beige Book survey of regional economies showed little thus far in the way of impact beyond housing construction and financing from the current crunch in, uh, housing construction and financing. Atlanta Fed Governor Lockhart commented, "So far, I have not seen hard or soft data that provide conclusive signs that housing problems are spilling over into the broad economy..." And, "I would like to see inflation sustained at a somewhat lower rate -- with emphasis on `sustained.' If inflation is allowed to accelerate, bringing it back down will be costly and painful..."
Governor Lockhart is a non-voting member until 2009 and so faces less public pressure than others, or the ECB today for example, but one would think he has a pretty good vantage point on the economy in overdeveloped Atlanta. Is it possible Toll Brothers management does not have Lockhart's phone number?
Nonetheless, with equity markets having already baked in at least 25bp from the Fed for Sep 18th, the probability of the Fed coming up with anything less (thereby disappointing a technically irrelevant constituency that happens however to pull the levers of public opinion) has to be seen as very small.
Yet despite the seeming inevitability of something the Fed's maneuvers thus far demonstrate its great reluctance to do, the debate (excellent summary today by the FT's Krishna Guha) as to whether a rate cut will actually do anything for the animal spirits of the abcp market or consumer confidence comes down fairly clearly against in m*'s mind.
In the "later" column, where recession fears are getting a pretty good airing at the expense of inflation fears (and moralists moralizing on the morals of bailouts, credit bubbles, and profligate Central Banks etc.) a few prominent economists are starting to gather. Chief among them is Martin Feldstein, of Harvard, NBER, and high off the last word at the Jackson Hole confab last weekend, where he said the possibility of a recession, based on what is happening in home construction and home finance, may be strong enough for an anticipatory response now from policymakers even at the expense of higher inflation "later."
m* says, what's the rush?
Look at the problems in the market transmission mechanism. Are rate cuts going to bring transparency to bank's off-balance sheet financing of the asset backed commercial paper market (a trust problem)? Are they going to do much to stabilize bids in credit markets for structured home-finance paper of heretofore rated but now unknown quality (an information problem)? Will they do much for the dozens of bankrupt mortgage originators, levered speculative funds, and ill-informed, ignorant, or just greedy investors with losses (an insolvency problem)?
Look at the problem in the housing market transmission mechanism. Home builders and speculators created an excess supply of housing. Are rate cuts going to speed the absorption of houses on the market to the point where builders will have reason to build more? Are rate cuts going to bring back appreciating prices enabling the MEW for consumption cycle to start again?
No. Time may be money, but money is not time. These problems need time.
Rate cuts now will make it easier for banks to hold onto, or demand higher prices for, the $250bn pipeline of deal debt committed to (should policy seek to socialize the swallowing of that bubble). Will that help bring down interbank lending rates? Sure. But vulture investors seeking to relieve banks of this burden are eyeballing double digit returns - levered of course. Is that a cry for help, now?
Rate cuts now will lower the discount rate for equities, making headlines and boosting morale, particularly for the classes with no exposure to equities, but they are unlikely to enjoy renewed access to sub-prime credit as a result. Rate cuts will lower the cost of capital for prime borrowers, perhaps, but prime borrowers do not seem to be suffering at this point.
If things are going to be as bad as the fearful fear, rates are going to have to go low enough to start the bubble machine again. There is plenty of time for that, (remember those monetary policy lags too!). The Fed has done enough, and through it's liquidity injections, is doing enough, for now. Give it time.
If m* is looking for justice, and there may be just a little of it corrupting the analysis today, at least the short squeeze in Countrywide is now definitively done. Sorry BoA. Maybe $18 should have been the "bail in" price!
Thursday, August 30, 2007
Labor(Capital) Day
Packed elbow to rib in a cacophonous six seat paint-can shaker implausibly airborne 800 feet above the ground, fighting for breath against senses of entitlement inflated to SUV size by a sham economy addicted to cheap debt, carrying a desperate need to out consume and out do rooted in a lifetime diet of spoon fed commercials and the easy calories of celebrity worship, mindless of nature's rigors or the rewards of patient cultivation of character or virtue, grimly wondering if their enemies below have surface-to-air or a surprise welcoming committee at the LZ - so begins the US holiday weekend for capitalism's winners according to Bloomberg News.
Fear not for m* however. For one thing, m* took the Rolls earlier in the week. (No shaking, forced intimacy, or cortisol floods and door to door, about the same). For another, while the clamoring masses of fake-tan attorneys, has-been movie stars, and assorted financial eel and remora are heading east, m*, ever the contrarian, will be heading back from whence they came to the wonderfully peaceful and empty late summer city.
While the holiday signals the official end to summer and the impending reality of m*'s packed fall agenda, idyllic thoughts of majestic mountain vistas, sparkling clear streams, sun drenched hikes, and yes, heated campfire discussions of monetary policy offer a temporary reprieve. m* is referring of course to the annual Kansas City Fed Symposium and central bankers' working holiday this weekend in Jackson Hole.
m* will not be attending of course, but in honor of the event and the final weekend of summer will be sitting down with two very recent papers from Michael Woodford, an occasional co-author with Chairman Bernanke and the esteemed intellectual godfather of inflation targeting and rule driven central bank decision-making now very much embedded in the thinking of current CB-ista. Why? Know thine enemy. It is Woodford of course who's work shows that monetary aggregates are largely irrelevant to the conduct of modern monetary policy, a viewpoint widely accepted among leading monetary economists today, implying of course that m* is not simply elusive but nonsensical too (and well, m* would have to agree!)
Of course, an effective inflation targeting policy requires an accurate and transparent measure of inflation. Dissenters to inflation targeting in the US frequently point to the vast discrepancy between government price indices and consumers' reported "sense" of inflation. No where is this more apparent than in the spread between the reality of rapidly rising home prices over the last ten years and the stagnant behavior of the much derided statistical construction, "owner equivalent rent."
As an illustration, consider the BOE. While the BOE follows an explicit inflations targeting mandate and thus adheres closely to many of the protocols expected in that regard, it also rather unusually includes direct asset prices (in particular home prices) into its price measures. The relevance of asset prices to measuring inflation is still open to debate in the academic world. But the BOE apparently believes that asset price levels do contain signaling information for inflation and an ability to influence the very important expectations component.
It may not be a coincidence then that Woodford believes the BOE comes closest to his idealized inflation targeting Central Bank. It is certainly no coincidence that the BOE has had m*'s vote for the hardest bank over the last three years - witness the performance of Sterling over that period. It will be interesting to see, now that inflation targeters are in charge in the US too and confronting a home finance crisis with larger potential ramifications, whether some greater recognition of the indicator that Greenspan pointedly ignored in price measures is warranted, particularly as popular sentiment views home price declines as analogous to a depressionary deflation. The announced theme of this weekend's symposium is housing, housing finance and monetary policy so this could be interesting.
Two papers by Woodford:
"How Important is Money in the Conduct of Monetary Policy?"
"Globalization and Monetary Control"
Meanwhile, Greg Ip in the WSJ "Bernanke Breaks Greenspan Mold" does a smashup job of burying former Fed Chairman Greenspan's crisis response approach of listening to the markets in relation to Chairman Bernanke's attempts to let the real economic data tell the story. Ip relates a quote from Greenspan during the deliberations on the 1998 LTCM crisis that shows dramatically how far apart the two philosophies for managing policy are.
"It would be wrong to say that the change in psychology is all ephemeral just because we have not seen it in the hard data yet," he told colleagues. "It is the change in value judgments that alters the real world."
In m*'s opinion, Greenspan saw his role as one of actively managing monetary policy, especially during times of crisis, through a forecast (using a very personal mosaic of indicators) of the animal spirits at work in the economy. Undoubtedly these forecasts were colored by his baptism in the 1987 crisis, and following this more intuitive policy, he fell back on the (appropriate) response to that crisis time and again. It is quite clear that in later crises, Greenspan gave the markets significant weight, really too much weight, in his assessments of future risk taking appetite in the economy and acted, erroneously, on those assessments.
It is the personal nature of those assessments, in the face of widespread evidence to the contrary (in particular the dramatic increases in mortgage debt and real estate values), the mistaken signals sent to the economy via inappropriate interest rate policy in response, and the long term consequences for the nation's standard of living as a result of the serial asset price bubbles, mal-investment and overconsumption, unprecedented explosion in debt, and inflation from a devalued dollar that incite Greenspan's critics, m* among them.
Bernanke, on the other hand and like Woodford, is an advocate of inflation targeting. Though he does not have that mandate at the US Central Bank, he has clearly discussed his desire to hew much more closely to the more mechanical adjustment mechanism such targeting espouses, with a healthy appreciation for expectations of course as befitting one of the foremost scholars on the Great Depression. Ironically, Greenspan's Vice Chairman, Alan Blinder, was also a proponent of for data-dependent incrementalist approach but he seems to have been less influential than one would have thought.
As has been widely reported during the current crisis, Bernanke has said while he will of course take whatever action necessary to preserve stability, he is attempting to hold off policy adjustments that effect the real economy as much as possible until data show a policy change is required. Not said but also clearly implied is that Bernanke supports an unwind in the degree of leverage promoted under his predecessor provided it can be done without dramatic effect on the real economy. While this may seem unresponsive to a vocal sector of the financial markets, it is a view widely shared, it seems to m*, in the central banking community globally.
The likelihood of success of that de-levering, whether success is even possible, even the actual definition of success are to m* still very much open questions. The problem is that it may be just one crisis too late to take that harder line. With a global system as leveraged as the current one, it's highly doubtful there is much less they can do than the inevitable blunt rate stimulus.
Happy Capital Day.
Fear not for m* however. For one thing, m* took the Rolls earlier in the week. (No shaking, forced intimacy, or cortisol floods and door to door, about the same). For another, while the clamoring masses of fake-tan attorneys, has-been movie stars, and assorted financial eel and remora are heading east, m*, ever the contrarian, will be heading back from whence they came to the wonderfully peaceful and empty late summer city.
While the holiday signals the official end to summer and the impending reality of m*'s packed fall agenda, idyllic thoughts of majestic mountain vistas, sparkling clear streams, sun drenched hikes, and yes, heated campfire discussions of monetary policy offer a temporary reprieve. m* is referring of course to the annual Kansas City Fed Symposium and central bankers' working holiday this weekend in Jackson Hole.
m* will not be attending of course, but in honor of the event and the final weekend of summer will be sitting down with two very recent papers from Michael Woodford, an occasional co-author with Chairman Bernanke and the esteemed intellectual godfather of inflation targeting and rule driven central bank decision-making now very much embedded in the thinking of current CB-ista. Why? Know thine enemy. It is Woodford of course who's work shows that monetary aggregates are largely irrelevant to the conduct of modern monetary policy, a viewpoint widely accepted among leading monetary economists today, implying of course that m* is not simply elusive but nonsensical too (and well, m* would have to agree!)
Of course, an effective inflation targeting policy requires an accurate and transparent measure of inflation. Dissenters to inflation targeting in the US frequently point to the vast discrepancy between government price indices and consumers' reported "sense" of inflation. No where is this more apparent than in the spread between the reality of rapidly rising home prices over the last ten years and the stagnant behavior of the much derided statistical construction, "owner equivalent rent."
As an illustration, consider the BOE. While the BOE follows an explicit inflations targeting mandate and thus adheres closely to many of the protocols expected in that regard, it also rather unusually includes direct asset prices (in particular home prices) into its price measures. The relevance of asset prices to measuring inflation is still open to debate in the academic world. But the BOE apparently believes that asset price levels do contain signaling information for inflation and an ability to influence the very important expectations component.
It may not be a coincidence then that Woodford believes the BOE comes closest to his idealized inflation targeting Central Bank. It is certainly no coincidence that the BOE has had m*'s vote for the hardest bank over the last three years - witness the performance of Sterling over that period. It will be interesting to see, now that inflation targeters are in charge in the US too and confronting a home finance crisis with larger potential ramifications, whether some greater recognition of the indicator that Greenspan pointedly ignored in price measures is warranted, particularly as popular sentiment views home price declines as analogous to a depressionary deflation. The announced theme of this weekend's symposium is housing, housing finance and monetary policy so this could be interesting.
Two papers by Woodford:
"How Important is Money in the Conduct of Monetary Policy?"
"Globalization and Monetary Control"
Meanwhile, Greg Ip in the WSJ "Bernanke Breaks Greenspan Mold" does a smashup job of burying former Fed Chairman Greenspan's crisis response approach of listening to the markets in relation to Chairman Bernanke's attempts to let the real economic data tell the story. Ip relates a quote from Greenspan during the deliberations on the 1998 LTCM crisis that shows dramatically how far apart the two philosophies for managing policy are.
"It would be wrong to say that the change in psychology is all ephemeral just because we have not seen it in the hard data yet," he told colleagues. "It is the change in value judgments that alters the real world."
In m*'s opinion, Greenspan saw his role as one of actively managing monetary policy, especially during times of crisis, through a forecast (using a very personal mosaic of indicators) of the animal spirits at work in the economy. Undoubtedly these forecasts were colored by his baptism in the 1987 crisis, and following this more intuitive policy, he fell back on the (appropriate) response to that crisis time and again. It is quite clear that in later crises, Greenspan gave the markets significant weight, really too much weight, in his assessments of future risk taking appetite in the economy and acted, erroneously, on those assessments.
It is the personal nature of those assessments, in the face of widespread evidence to the contrary (in particular the dramatic increases in mortgage debt and real estate values), the mistaken signals sent to the economy via inappropriate interest rate policy in response, and the long term consequences for the nation's standard of living as a result of the serial asset price bubbles, mal-investment and overconsumption, unprecedented explosion in debt, and inflation from a devalued dollar that incite Greenspan's critics, m* among them.
Bernanke, on the other hand and like Woodford, is an advocate of inflation targeting. Though he does not have that mandate at the US Central Bank, he has clearly discussed his desire to hew much more closely to the more mechanical adjustment mechanism such targeting espouses, with a healthy appreciation for expectations of course as befitting one of the foremost scholars on the Great Depression. Ironically, Greenspan's Vice Chairman, Alan Blinder, was also a proponent of for data-dependent incrementalist approach but he seems to have been less influential than one would have thought.
As has been widely reported during the current crisis, Bernanke has said while he will of course take whatever action necessary to preserve stability, he is attempting to hold off policy adjustments that effect the real economy as much as possible until data show a policy change is required. Not said but also clearly implied is that Bernanke supports an unwind in the degree of leverage promoted under his predecessor provided it can be done without dramatic effect on the real economy. While this may seem unresponsive to a vocal sector of the financial markets, it is a view widely shared, it seems to m*, in the central banking community globally.
The likelihood of success of that de-levering, whether success is even possible, even the actual definition of success are to m* still very much open questions. The problem is that it may be just one crisis too late to take that harder line. With a global system as leveraged as the current one, it's highly doubtful there is much less they can do than the inevitable blunt rate stimulus.
Happy Capital Day.
Friday, August 24, 2007
Bullets over bridges
Senator John Warner's public statements to start bringing troops back from Iraq seems to, m*, an event of note in the painful travesty this Administration's unnecessary war of choice has become.
Leaving aside the immense human toll for the moment, the roughly $500bn spent per year, or roughly $2 trillion already spent, represents the entire budget laid out by the American Society of Civil Engineers for bringing the crumbling US infrastructure up to acceptable levels.
In the panalopy of possible BHAG's available to the Administration five years ago, the focus on the foreign over the domestic now seems not only woefully unsuited for the times, but a tremendous missed opportunity for the Republicans, their friends in business, and the nation. As a welcome fiscal stimulus after the 2001 capital spending recession, an investment in the future productivity of the nation, and a way to keep Halliburton's coffers full with nice safe work at home, a China-scale infrastructure rebuild would have been a political triple play.
Isn't it ironic then that after five years and $2 trillion consumed in a useless war funded by debt sold to Asian Central Banks, the only way we'll see more repairs of repairs of repairs is with the help of this guy. How do you say EZPass in Chinese?
Leaving aside the immense human toll for the moment, the roughly $500bn spent per year, or roughly $2 trillion already spent, represents the entire budget laid out by the American Society of Civil Engineers for bringing the crumbling US infrastructure up to acceptable levels.
In the panalopy of possible BHAG's available to the Administration five years ago, the focus on the foreign over the domestic now seems not only woefully unsuited for the times, but a tremendous missed opportunity for the Republicans, their friends in business, and the nation. As a welcome fiscal stimulus after the 2001 capital spending recession, an investment in the future productivity of the nation, and a way to keep Halliburton's coffers full with nice safe work at home, a China-scale infrastructure rebuild would have been a political triple play.
Isn't it ironic then that after five years and $2 trillion consumed in a useless war funded by debt sold to Asian Central Banks, the only way we'll see more repairs of repairs of repairs is with the help of this guy. How do you say EZPass in Chinese?
Friday, August 17, 2007
Pretty simple
Morgan Stanley's Serhan Cevik, left to his own devices and thinking big picture while the senior strategists are on vacation, comes up with a polite one paragraph worth reading in "the Limits of Engineering" on the MS-GEF page. Wonder what Dick Berner and the amenable gang will say when they get back!
Middle East/North Africa
Limits of Engineering
August 16, 2007
By Serhan Cevik | London
Middle East/North Africa
Limits of Engineering
August 16, 2007
By Serhan Cevik | London
...The abundance of ‘market’ liquidity turned out to be a self-reinforcing phenomenon.Central banks’ coordinated attempt to flood money markets with cash may ease the immediate pain, but would not really address systemic threats. This is why we need to dig deeper and identify underlying fragilities in the global financial system. It seems that the ‘original sin’ was the extreme monetary easing campaign that ended up lowering the average short-term interest rate in the world from 4.8% in 2000 to 1.6% in 2003. Of course, with real interest rates declining from 4.3% to 0.8% over this period, it was not surprising to witness the emergence of a global liquidity wave and greater appetite of risk-taking among investors. However, the abundance of ‘market’ liquidity turned out to be a self-reinforcing phenomenon and kept expanding even as central banks tightened the policy stance to 3.7% last year and 4.4% of late. In other words, despite higher (real) interest rates bringing an end to the expansion of monetary liquidity, financial market liquidity increased (with occasional moments of pause) and fuelled the search for higher returns in riskier assets. But what is (or possibly was) behind the disconnection between monetary and market liquidity? We think that a couple of factors have made the most significant contribution to the pool of global liquidity. First, the recycling of current account surpluses has helped to de-link financial conditions from the behaviour of short-term interest rates. Second, financial innovation and the rise of new investors have become far more important in determining market liquidity. As one would have expected, these new financial trends depressed volatility and set the stage for greater risk-taking through highly leveraged derivative-based instruments. However, this type of liquidity is partly a function of confidence and thereby vulnerable to sudden changes in sentiment (see The Curse of Alpha, November 16, 2006). Hence, while structural factors are likely to keep the ‘excess savings’ channel intact, the ‘high-tech market liquidity’ channel is fragile and can quickly disappear when an unexpected shock occurs...
Legion of doom
The goldbugs arrived today. m* received the latest "Greed and Fear" from the inimitable Christopher Wood of CLSA and immediately checked the stock of canned food in the cupboards. If ever m* thought about dipping into those REITS down 25% or doubted for a minute those decoupling skeptics and declaimers of fiat money, this latest cured all weakness.
And Bernard Connolly at AIG, the walking Wikipedia of economic theory classification, sends his best as well. Only 18 pages but the usual tasty seminar in history of economic thought, replete with footnotes taking up entire pages, awaits.
These latest missives on "The Crisis" and policy perspective are almost too good to share, and almost too scary not to. Unfortunately these are not yet in the public domain, as m* understands it anyway.
However, as an altogether safer (you can put the ammunition away), and possibly more sane option, m* offers a recent note from two prominent macro-economists on the question "what do we want from our central banks in this situation?"
The note is a response to Martin Wolf's appropriately titled scare-mongering FT column "Fear Makes a Welcome Return." Incidentally m* has noticed a clear pattern of commentary in the FT of late strongly advocating what m* calls the moralist case, (first described as such in notes from the folks at Toqueville - yep more goldbugs), which deems a puritanical cleansing of credit excess only fitting and stealthily argues for "free banking" ie: permitting bank failures, thus re-introducing the natural counterweight to animal spirits, moral hazard, back into the system. That is revolutionary stuff from our Socialist cousins across the pond.
This however is not. It is not even sensational. It is so sane as to be boring. Maybe we could use some of that right about now. Thank you, gentlemen.
And Bernard Connolly at AIG, the walking Wikipedia of economic theory classification, sends his best as well. Only 18 pages but the usual tasty seminar in history of economic thought, replete with footnotes taking up entire pages, awaits.
These latest missives on "The Crisis" and policy perspective are almost too good to share, and almost too scary not to. Unfortunately these are not yet in the public domain, as m* understands it anyway.
However, as an altogether safer (you can put the ammunition away), and possibly more sane option, m* offers a recent note from two prominent macro-economists on the question "what do we want from our central banks in this situation?"
The note is a response to Martin Wolf's appropriately titled scare-mongering FT column "Fear Makes a Welcome Return." Incidentally m* has noticed a clear pattern of commentary in the FT of late strongly advocating what m* calls the moralist case, (first described as such in notes from the folks at Toqueville - yep more goldbugs), which deems a puritanical cleansing of credit excess only fitting and stealthily argues for "free banking" ie: permitting bank failures, thus re-introducing the natural counterweight to animal spirits, moral hazard, back into the system. That is revolutionary stuff from our Socialist cousins across the pond.
This however is not. It is not even sensational. It is so sane as to be boring. Maybe we could use some of that right about now. Thank you, gentlemen.
Dead dogs addendum
For the wonks among you, some weekend candy. VoxEU has a detailed explanation of the Fed and ECB repo operations last week.
Tuesday, August 14, 2007
Central Banks: Butt out!
Andy Xie, for a time one of the most entertaining and outspoken economists on Wall Street, calls it like he sees it in today's FT. His message? Time for a bit of truth and consequences.
Andy Xie in the FT.
Andy Xie in the FT.
Thursday, July 19, 2007
Undercurrents
m* has been digesting the torrent of "progress reports" and related commentary, all released over the last day or two. The trends in place before this week are still in place. China is expanding at an astounding and accelerating rate. As measured inflation is at the higher end of our official comfort zones with housing pressing down and global growth pressing up. Forecasts for US growth are coming in a touch with consumer spending starting to soften. But the Fed remains on hold, mindful of the connection between food inflation and un-anchored expectations, while also keeping an eye on stress in the financial sector, etc, etc... Meanwhile oil continues to climb and the dollar continues to melt. This is not new.
However those buyers of bonds back to 5% are to m*'s way of thinking playing a game whose rules may have changed since the last financial crisis. Granted, is there anyone who has not been conditioned since this liquidity party started two decades ago to believe it is the central banks' responsibility to answer any and every crisis that threatens the steady march of credit expansion with a flood of cheap money to allow the party to continue? Probably not. We know the no consequences Greenspan put has replaced decades of dour punchbowl management.
But central banks now face a tougher set of conditions than they have in the past. The global economy is synchronized like never before and running full tilt. Inflation, not just the dollar weakening kind or the asset price kind, but real inflation, is starting to crop up in all sorts of places and is as globally linked as the supply chains that feed our people and our economies. For example food prices were reported as rising at 4.5% or higher in the US, China, and Israel this week. Central banks around the world are in tightening mode as inflation targets are being exceeded and expectations risk becoming un-anchored. The benign inflation environment that has existed for two decades and allowed central bankers considerable latitude to lower rates rapidly in response to fluctuations in the supply of credit no longer exists.
Central bankers today face a decision that was par for the course for bankers of old - whether to choose the primary goal of price stability or the secondary goal of full employment? In previous eras, central bankers felt obligated to occasionally put the brakes on, to allow unemployment to rise, even to cause it to rise by raising rates. However that has become much harder to do these days. With the shift from bank lending to capital markets finance, the opacity of credit creation through derivatives, and dare I say it, an intolerance for hardship of any kind among voters. These days the levers at the Fed's disposal need to move much farther to have an impact while the will to move them may be less than ever before.
The Greenspan era Fed, with it's belief in a new and "permanently" higher rate of productivity afforded by the internet (!) and an intense fear of a Japan style deflation (remember "helicopter Ben" and those used car prices?) believed to the horror of monetarists and economic moralists everywhere that it had the power to choose full employment without affecting price stability. However, like the trade deficit, entitlement healthcare spending, tax breaks for the rich, profligate oil usage, and ill-conceived and incompetently run wars in foreign lands, that is check written that must eventually be paid (in devalued currency naturally). The dismissal as a society of difficult trade-offs and hard choices is a symptom of these times.
What about the unprecedented amount of leverage in the system? Does that not mean the banks can talk about vigilance all they want but will still be forced to rescue asset markets and leveraged financial intermediaries should a crunch occur? Perhaps. At the margin, what matters is employment - the Fed's second policy goal. Changes in asset prices by themselves do not factor into the Fed's employment calculus. Wealth effects - the health of the "animal spirits" that incite both spending and entrepreneurial risk taking are probably real, as we've learned in the last housing boom. However, unless collateral can not get a loan, the current Fed leadership, steeped in scholarship on the Great Depression and the breakdown of credit intermediation as it is, may not be as sensitive to dampened spirits as the previous leadership seemingly was. Conceivably, there could be severe distress in financial markets, and even a pensions crisis, without a major policy change from the Fed. Only if unemployment threatened to pick up substantially would the Fed be obligated to shift policy.
Is the Bernanke Fed up to the challenge? It is an interesting situation to say the least.
However those buyers of bonds back to 5% are to m*'s way of thinking playing a game whose rules may have changed since the last financial crisis. Granted, is there anyone who has not been conditioned since this liquidity party started two decades ago to believe it is the central banks' responsibility to answer any and every crisis that threatens the steady march of credit expansion with a flood of cheap money to allow the party to continue? Probably not. We know the no consequences Greenspan put has replaced decades of dour punchbowl management.
But central banks now face a tougher set of conditions than they have in the past. The global economy is synchronized like never before and running full tilt. Inflation, not just the dollar weakening kind or the asset price kind, but real inflation, is starting to crop up in all sorts of places and is as globally linked as the supply chains that feed our people and our economies. For example food prices were reported as rising at 4.5% or higher in the US, China, and Israel this week. Central banks around the world are in tightening mode as inflation targets are being exceeded and expectations risk becoming un-anchored. The benign inflation environment that has existed for two decades and allowed central bankers considerable latitude to lower rates rapidly in response to fluctuations in the supply of credit no longer exists.
Central bankers today face a decision that was par for the course for bankers of old - whether to choose the primary goal of price stability or the secondary goal of full employment? In previous eras, central bankers felt obligated to occasionally put the brakes on, to allow unemployment to rise, even to cause it to rise by raising rates. However that has become much harder to do these days. With the shift from bank lending to capital markets finance, the opacity of credit creation through derivatives, and dare I say it, an intolerance for hardship of any kind among voters. These days the levers at the Fed's disposal need to move much farther to have an impact while the will to move them may be less than ever before.
The Greenspan era Fed, with it's belief in a new and "permanently" higher rate of productivity afforded by the internet (!) and an intense fear of a Japan style deflation (remember "helicopter Ben" and those used car prices?) believed to the horror of monetarists and economic moralists everywhere that it had the power to choose full employment without affecting price stability. However, like the trade deficit, entitlement healthcare spending, tax breaks for the rich, profligate oil usage, and ill-conceived and incompetently run wars in foreign lands, that is check written that must eventually be paid (in devalued currency naturally). The dismissal as a society of difficult trade-offs and hard choices is a symptom of these times.
What about the unprecedented amount of leverage in the system? Does that not mean the banks can talk about vigilance all they want but will still be forced to rescue asset markets and leveraged financial intermediaries should a crunch occur? Perhaps. At the margin, what matters is employment - the Fed's second policy goal. Changes in asset prices by themselves do not factor into the Fed's employment calculus. Wealth effects - the health of the "animal spirits" that incite both spending and entrepreneurial risk taking are probably real, as we've learned in the last housing boom. However, unless collateral can not get a loan, the current Fed leadership, steeped in scholarship on the Great Depression and the breakdown of credit intermediation as it is, may not be as sensitive to dampened spirits as the previous leadership seemingly was. Conceivably, there could be severe distress in financial markets, and even a pensions crisis, without a major policy change from the Fed. Only if unemployment threatened to pick up substantially would the Fed be obligated to shift policy.
Is the Bernanke Fed up to the challenge? It is an interesting situation to say the least.
Subscribe to:
Posts (Atom)
Ricardo Caballero and Arvind Krishnamurthy: A liquidity crisis is taking place where investors, banks, and funds are scrambling for liquidity. Several hedge funds run by prominent investment banks in the US and abroad have liquidated or have suspended convertibility.
Paradoxically, when viewed as a whole there is sufficient liquidity in the financial system. Banks are well capitalised and flush with liquidity. Just a few weeks ago stock markets were soaring, investors were optimistic, and the VIX hit 13, not far from its 9.5 all time low. Yes, the residential real estate market in the US was declining and creating a mess in the subprime market.
But it was generally understood that the scale of these subprime losses was small in relation to the US and world economy. Even if all subprime mortgages and related CDOs were to lose all value, this would amount to just 2.5 per cent of US wealth. A more realistic, yet still pessimistic scenario puts the potential losses at $400bn, less than 1 per cent of US wealth. These losses could hardly have reversed the liquidity position of the financial sector. Hence, many pundits used the word "contained" in describing the subprime losses. Yet, it is clear that there is a liquidity crisis unfolding before our eyes.
Why? The reason is a rise in uncertainty - that is, a rise in unknown and immeasurable risk rather than the measurable risk that the financial sector specialises in managing. The financial instruments and derivative structures underpinning the recent growth in credit markets are complex. Market participants cannot refer to a historical record to measure how these financial structures will behave during a time of stress. Thus, today there is considerable uncertainty about who will and will not lose money in the credit market turmoil.
To understand how uncertainty can move an economy from excess liquidity to a liquidity crunch, an analogy might be useful. In the children’s game of musical chairs, when the music stops, only one child will be left without a seat. However if the children are confused about the rules and each is convinced that they will be the one left without a seat, chaos may erupt. Kids may start grabbing on to chairs, running backwards, etc.
In the same way, in today’s market uncertainty is leading every player to make decisions based on imagined worst-case scenarios. Market players that have the liquidity stay out of markets or pull back dramatically. But the financial markets need participants and their liquidity in order to function. When much of the market disengages due to uncertainty, the effective supply of liquidity in the financial system contracts. Those that need liquidity are unable to get it and financial markets turn illiquid.
What should central banks do in this case? They must find a way to re-engage the private sector's liquidity. Understanding that uncertainty is the cause of the disengagement is the start of finding the solution. A first step in reducing agents' uncertainty is for the central bank to clarify how it will act if agents’ worst case scenarios come to pass.
The central bank’s mission is to stabilise the economy as a whole and not individual participants. When viewed as a whole, the worst case scenarios that guide the behaviour of each market participant cannot simultaneously occur. Like musical chairs, when the music stops, only one child will be left without a seat, not every child.
The subprime shock at the end of the day is a small shock; it is only the actions of panicked investors that make it appear large. A central bank that understands this point will convincingly promise large liquidity injections in the event of a meltdown. The likelihood of having to deliver on the promise is minimal, but the reduced anxiety fostered by such a commitment restarts private liquidity circulation and helps restore normalcy.
It is important to understand that this is all about information and not about real liquidity additions. We do not have a true liquidity shortage on our hands; we only have one because of the reactions of an anxious private sector. Talking and providing information and certainty can go a long way to reducing uncertainty. A rate cut may be the right tool, but it is important not for its direct liquid addition, and instead for what it conveys about the central bank's readiness to act if things do get worse.
Will the Fed and other central banks around the world act appropriately? The early reactions are positive. The ECB was first to act, injecting more than $214bn in the last two days. The Fed followed with a more modest $38bn on Friday, and the rest of the central banks of the world did their share, lending over $73bn to the market.
It may also be that some of investors’ uncertainty stems from not knowing how Fed chairman Bernanke will react in case of a meltdown. Is he too much of an inflation targeter and oblivious to the workings of financial market? Not likely. From his extensive academic work on these matters, it is apparent that he is quite aware of the importance of credit markets to the functioning of the economy and the cost of the central bank failing to identify a liquidity event in time. It may well be time to start buying put options on the VIX.
Reference: R Caballero and A Krishnamurthy, "Collective Risk Management in a Flight to Quality Episode", forthcoming in The Journal of Finance