Crisis Symptoms, Not Disease, Treated by Banks

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The New York Sun

London — The world’s central banks no longer seem able to shock and awe the markets with a blasts of liquidity.

Yesterday’s move by the Federal Reserve, the European banks, and the Bank of Japan, to douse the global banking system with $184 billion may get us through the week without another catastrophic failure, but it does nothing to halt the downward spiral into debt deflation.

“The central bank action treats a symptom of the disease, not the disease itself,” the chief economist at Insinger de Beaufort, Stephen Lewis, said. “It is a palliative. At root, there is no way of imbuing worthless financial claims with value.”

The yield on three-month Treasury notes remains near at zero — a level last seen after Pearl Harbor — reflecting a near total loss confidence in all financial instruments.

We are dangerously close to a $3.5 trillion collapse of America’s money market fund industry. “It’s an incredibly serious issue. A tipping point in this crisis would be when you have a run on money markets, and we are right on the cusp of that,” PIMCO’s portfolio chief, Paul McCulley, said.

The Fed, the Treasury, and Congress are still scrambling to catch up with this crisis, responding to events with piecemeal measures made up on the hoof. Obviously it is not enough. The RTC was created in 1989 to absorb the bad debts from the Savings and Loans crisis. The assets of the bankrupt lenders were taken over by the state, preventing fire-sales that can drive prices even lower in a self-feeding spiral. It worked well enough. The RTC sat on the devalued assets until the bloodbath was over. In the end it made a nice profit.

How much would it cost? A former chief economist at the IMF, Kenneth Rogoff, says the bill would run to at least $1 trillion. This would increase the American government debt from 48% to 55% of GDP (under IMF measures) — still lower than that of Germany, France, Italy, or Japan.

The chair of the House Banking Committee, Barney Frank, said he is ready to embrace the idea. “There have been a series of ad hoc interventions that have not worked. Has the private market made so many mistakes there needs to be some public intervention? We have to consider whether to create another entity,” he said.

Yet days goes by, banks topple, and nothing concrete emerges from Washington. Capitol Hill is shutting down for a month. The politicians are in election mode. Congressional leaders say the issue may have to wait until the new session in January. The drift is eerily reminiscent of early 1931, in the months before the global system snapped with the failure of Austria’s Credit Anstalt.

The Fed and the Treasury seem out of their depth. It is shocking to learn that the chief of the New York Fed, Tim Geithner, was not aware until this weekend that AIG plays a key role at the epicenter of the world’s derivative system, underpinning the a massive nexus of CDO credit contracts.

No doubt Treasury Secretary Paulson has an impossible task, but it is a moot point whether his decision to seize the mortgage giants Fannie Mae and Freddie Mac was itself the trigger of the Lehman/Merrill/AIG debacle.

He bailed out bondholders — mostly Chinese, Japanese, and Russian state entities — in order to ensure they would continue to fund the American housing market, and to underpin the dollar. But to defend himself against accusations of moral hazard, he offered up the shareholders for ritual sacrifice. He did so even though the Treasury itself had encouraged investors to inject billions of fresh capital, and had repeatedly insisted that the twins were in good health.

The result was to jam shut the window for the long list of struggling lenders, brokers, and insurers seeking fresh capital. Who will invest anything if Washington can so capriciously change the rules and expropriate their shares at a stroke? History will judge whether he lost sight of his mission.

As for the world’s central banks, they have to ask themselves whether they risk losing the plot altogether by harping on about inflation when the imminent danger is debt deflation.

The Fed’s Tuesday statement suggesting the risks of inflation and slowing growth are roughly matched is so tone-deaf, and so implausible after the $50 collapse in oil prices, that it should be framed for posterity. The central banks were too loose during the credit bubble. They are too tight now.

This crisis will not begin to abate until monetary gods at the Fed and the ECB make it clear at long last that they grasp the full of the crisis by slashing interest rates in a single concerted action. That will shock and awe.

The New York Sun

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