A LICENSE TO PRINT MONEY
except
Actually, it’s much better
than this. It’s a license to print digital money – so much digital money
that nobody illegal immigrants use printed money exclusively. They
send it to relatives back home. So, there can never be a run on the banks.
Any money withdrawn from one bank winds up in another bank. Digital money
can’t go in your pocket. Nobody who speaks English and who has a bank
account uses paper money to make most of his transactions.
This has been the fulfillment
of bankers’ dreams for five centuries: no more bank runs by the public. No
more lines in front of banks.
The problem today is all those
hedge fund managers and mortgage brokers, who packaged mortgages and other
collateralized debt obligations (CDO’s), and who are now facing default by
the borrowers. There is no guaranteed market for these new, creative, and
untested forms of debt.
In mid-August, 2007, the
markets for billions of dollars worth of these supposedly marketable
securities simply disappeared at anything like a retail price. Henry Liu
comments.
In a financial crisis, there
may simply not be enough credit-worthy borrowers at any interest rate
level and the number of sellers stay stubbornly larger than the number of
buyers because sellers need to sell precisely because they do not have
credit worthiness to borrow even at low interest rates and buyers stay on
the sideline waiting for even lower prices.
This is the problem facing the
FED and other central bankers. The outfits that have run up the debts to
the banks are no longer credit-worthy. They now face bankruptcy. They
cannot unload their assets at anything like book value. The commercial
banks lent hundreds of billions of dollars to them, and in a panic
meltdown, these assets fall in value. The FED can pump in money, but in a
panic, banks will buy T-bills, not the assets that are threatened.
This is why the FED has
announced that it will accept subprime mortgages as collateral. But this
still means mass inflation if it has to buy all of them. The FED must
create monetary base money to buy this junk, and then commercial banks
expand their loans to take advantage of the FED’s increased reserves. They
will not loan to struggling hedge funds and similar sinking ships.
When the Fed adds liquidity
directly into the banking system through the discount window, it injects
high-power money into banks by making interest rate for overnight
interbank banks loans within its set target. The theory is that banks will
in turn be able to make loans at interest rates deemed appropriate by the
Fed, thus relaying the added liquidity to the market in multiple amounts
because of the mathematics of partial reserve.
This will inflate the economy.
It will not provide solvency for highly leveraged hedge funds.
With deregulated global
financial markets, central bank capacity for adding liquidity to the
banking system is constrained by its need to protect the exchange value of
its currency. For the US, which depends on foreign central banks to fund
its twin deficits, any drastic fall of the dollar will itself create a
liquidity crisis from foreign central banks shifting out of dollar in
their foreign exchange reserves.
If the dollar falls in
relation to other currencies, the Treasury will have to raise interest
rates to attract replacement money. That money may come from newly
liquified American banks, but that does no good for the liquidity squeeze
of the private capital markets. Here is what the FED is facing:
The current challenge is one
of returning an abnormal economy of excess liquidity to an economy of
normal liquidity without extinguishing the flame of liquidity entirely.
The period of stress will be the time it will take to work off the excess
liquidity, to turn the liquidity boom back to a fundamental boom. It is
not possible to preserve abnormal market prices of assets driven up by a
liquidity boom if normal liquidity is to be restored. All the soothing
talk about the fundamentals of the economy being strong notwithstanding
the debt bubble is insulting to the thinking mind.
Bernanke’s FED tried from
February, 2006 to mid-August, 2007, to move the economy from excess
liquidity to "normal" liquidity. But that is what the FED has tried to do
ever since 1920. It never sticks to the program because of the resulting
liquidity crisis and recession.
Will the stock market hold up,
once it is clear that the FED’s money is insufficient to re-liquify
credit-unworthy borrowers? Will the economy remain positive? Liu does not
think so.
This is a debt economy fed by
a liquidity boom. When the liquidity boom turns to bust, all the strong
fundamental indicators such as corporate earnings will wilt from a debt
crisis. Asset value cannot be held up by simply adding excess liquidity
forever without creating hyperinflation. Also, some liquidity problems,
such as those caused by a loss of market confidence, cannot be solved by
merely injecting money into the financial system which in fact will only
add to the problem. Restoring market confidence requires a rational
restructuring of the economy to absorb excess liquidity.
So, having solved the age-old
problem of bank runs by depositors, the commercial bankers are now facing
massive default by their borrowers. If it’s not one thing, it’s another.
The stock market faces a problem. So does the corporate bond market. "When
debts are not repaid, financial value is destroyed which will be expressed
in falling asset prices. This loss of value will need to be reckoned in
the economy."
The FED loaned $2 billion to
the four largest U.S. banks on August 22. This was through the discount
"window." Why lend to banks? Why not lend directly to faltering hedge
funds? Liu has an explanation.
However, the Fed’s actions
reflected a shift of the focus of concern from hedge funds towards banks
who loaned the hedge funds money to trade with leverage. Banks are also
exposed to the problem of having committed credit lines to financial
institutions with subprime exposure, such as mortgage lenders or
specialist investment vehicles. Banks have also arranged loans to risky
firms such as buy-out groups, which they had planned to sell into a debt
market that had evaporated overnight. An estimated $300 billion of unsold
loans are sitting on bank balance sheets, gobbling up funds pushing up
reserve requirements.
If he is correct about $300 billion of unsold loans, then the FED faces a
true disaster.
I think Bernanke’s attempt to
wring liquidity out of the system was successful. The FED is now running
like mad to reverse this policy.
CONCLUSION
The FED keeps intervening to
make things better, and the result seems to be systemic vulnerability.
This is the fate of government intervention generally. It produces the
opposite of what the planners promised.
If nothing succeeds like
failure, then the FED may soon be able to add a spectacular chapter to its
success manual.
garynorth@garynorth.com
