How Worried Is the Fed?

In a move that surprised many observers for its aggressiveness, the Federal Reserve Board on Tuesday, Dec. 16^th, lowered the federal funds rate, the interest rate at which banks lend to one another, from 1% to a range of 0 to .25%. Many observers had expected a .50% cut, not the .75 to 1.0% cut that the Fed has effected. The lowering of the interest rate points to a Fed extremely worried about the health of the economy going forward.

The Fed also announced other efforts to fight the specter of deflation, using, as it says, “all available tools to promote the resumption of sustainable economic growth and to preserve price stability.” These tools include supporting

the functioning of financial markets and stimulat[ing] the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Federal Reserve Building

Together with the interest rate cut, these policies give insight on just how concerned federal officials are about the state of the economy. With job losses increasing, credit still tight, and prices deflating, the Fed wants to pump a flood of liquidity into the system to prevent a disastrous deflationary spiral.

The incoming Obama administration is also promoting an immense stimulus package that will pump even more money into an economy that it and the Fed are trying to reflate. Congress’s cooperation, with Democratic majorities, seems assured, although the defeat in the Senate of the auto bailout bill may portend a willingness on the part of Republicans to be obstructionist if they see political advantage.

The trouble is that if these efforts don’t work, what other ammunition do  the Fed, Congress, and President-elect Obama have left? If the auto companies fail, what will the resulting shock do to the crisis of confidence the economy is in? TARP money for the automakers has yet to be forthcoming (as of this writing), and people generally seem so sour on the automakers, not without reason, that President Bush and Henry Paulson seem reluctant to drink from this cup.

I suppose one could point to the equities market and see a glimmer of hope, but that’s, at this stage, fool’s gold. With the recent volatility of those markets, how can anyone rely upon them?

And even if the Fed and Congress through monetary and fiscal policies manage to reflate the economy, what then? With the world awash in liquidity, a new specter looms: inflation and its attendant risk, hyperinflation.

By the way, lest you think I’m all gloom and doom, Merry Christmas. Look out for the New Year.

Image courtesy of wwarby’s photostream at Flickr and used under license of Creative Commons.

No Bailout for Automakers? Remember Fallout from Lehman Collapse

A refusal to extend $25 billion in bridge loans to Ford, Chrysler, and GM could have catastrophic consequences for the economy similar to those experienced after the failure of Lehman Brothers. In mid-September of this year, you’ll remember, Treasury refused to loan Lehman any capital or to offer a line of credit to any purchaser of Lehman as the Federal Reserve had offered to J.P. Morgan Chase in its purchase of Bear Stearns in March. When Treasury walked away from offering support, first Bank of America and then Barclays walked away. Lehman was doomed. And so, it seems, was the economy. Credit markets tightened; commercial paper contracted; banks refused to loan to other banks, not trusting that they’d be paid back; Bank of America bought Merrill Lynch; Treasury bailed out AIG; and Congress finally agreed to provide another $700 billion to rescue the financial system. Lehman’s failure triggered a crisis in the financial system worldwide. All of this is laid out in The Financial Times in an excellent article entitled “The Lehman legacy: Catalyst of the crisis.”

The U.S. Department of the Treasury

In hindsight, Treasury Secretary Henry Paulson should have offered guarantees similar to those that enabled the purchase of Bear Stearns. If he had done so, perhaps the present liquidity crisis could have been avoided or, at the least, been put off another few weeks or months. Except for giving more time to fix the mess, it’s questionable what putting the disaster off another few weeks would have accomplished. But where are we now? Sinking into a liquidity trap with the possibility of a deflation spiral on the horizon. And if you’re bailing out Bear Stearns and AIG and then pumping capital into a long list of banks from the $700 billion, wouldn’t guaranteeing the capital that Bank of America or Barclay’s would have used to purchase Lehman have been worth it?

Now Secretary Paulson seems squeamish about aiding Detroit, pleading that the $700 billion approved by Congress did not authorize him to rescue the three automakers. The Secretary, however, also isn’t using the money to buy banks’ toxic assets, which was the whole basis of his proposal to Congress to thaw credit markets. Once again, the Secretary hesitates in rewarding companies who’ve miscalculated markets, certainly an understandable apprehension in a free market economy. Moral hazard is not an empty concept.

The problem, however, is that failing to rescue such firms may put the whole system at risk as appears to have happened with the failure of Lehman. Systemic risks may not only inhabit financial firms. In fact, the subsequent credit freeze and lack of confidence has directly affected automakers, foreign and domestic. The purchase of autos requires credit, and banks simply aren’t lending on terms that most people can afford. It’s hard to blame the banks; they don’t have the confidence as yet that they’ll be paid back. But what will happen to confidence if Detroit is allowed to fail?

Be wary of those like Mitt Romney, who advocate the Russian Roulette of Chapter 11 bankruptcy for the three firms. No one likes the fact that the three are being saved from their own faulty decisions of the past, but to allow one or more of them to go under presents a systemic risk that the country may never recover from. The spiral of deflation that could result would be an absolute catastrophe. If you think we’re in a crisis of confidence now, wait until these three go under. You’ll see a lack of confidence in American leadership and institutions that will have worldwide ramifications.

Image of Treasury building courtesy of drstout’s photostream at Flickr and used under license of Creative Commons.

Peter Schiff — Getting It Right?

Peter Schiff, supporter of Ron Paul and, along with a few others, predictor of the current economic malaise, certainly shows up Arthur Laffer, Ben Stein, Caputo, et al., in this video.

Ref.: Andrew Sullivan, “The Daily Dish”

Be careful, however, in glorifying him too much, as this second video shows:

See what I mean?

How Wall Street and Government Calculate

The NYT blog Laugh Lines includes a short skit from an Abbot and Costello routine that may show us the seeds of the present financial disaster:

Let’s see, Costello’s math must have been used by Bear Stearns, Lehman Bros., Merrill Lynch, AIG, Fannie Mae, and Freddie Mac, and who knows who else, right?

Waxman Wants to Know What Bankers Are Doing with Bailout Funds

Curious about what’s been happening to the money you loaned to all of those big financial institutions? Today’s Washington Post contains a story entitled “Waxman Seeks Bank Data on Use of Bailout Funds” that should engender justified indignation.

One of the keys to the story is revealed in the paragraph that indirectly quotes banking industry officials justifying the paying of bonuses. These unidentified officials note “that bonuses are a normal part of compensation packages. The fact that the allocations on compensation so far in 2008 are identical to last year suggests that the bailout money will be not used to boost bonuses.”

Wait a minute: The bailout funds “will not be used to boost bonuses,” but they will be used to pay bonuses at the same rate as the year previous? Did I understand that correctly? It’s been a disastrous year for banks, but they’re still paying bonuses at last year’s rate? Why are they paying bonuses at all? And banking institutions “fully intend to use the money to start making loans”? Right, they’re not going to hoard it; they’re only using it as a “substantial cushion against the adverse effects of the weakening economy,” as the last line of the story reveals. In other words, taxpayers have forked over hundreds of billions of dollars to pay bonuses at last year’s rate, as if bonuses should be paid at all, and to provide cushions against a failing economy. Lord, it is fun to be taken to the cleaners, isn’t it?

As emseyb, I wrote a slightly different version of this post in the comment section to the article at the Washington Post.

Image (modified) of Congressman Waxman by Bridgette Blair in Public Citizen’s photostream at Flickr and used under Creative Commons license.

Connected but Nobody’s in Charge

Thomas Friedman has a piece in today’s NYTimes that explains some of the adverse consequences of globalized banking.  He relates the story of Iceland (“The Great Iceland Meltdown”), whose banks (see Kaupthing Bank as an example), freed from state ownership, attracted deposits through high interest rates and subsequently went on a lending binge. When those loans curdled — Icelandic banks apparently did not involve themselves in the U.S. subprime mortgage market — the banks couldn’t finance their debts, and depositors panicked. Those depositors, many of them British universities, hospitals, police departments, and municipal governments, to the tune of $1.8 billion, could not get their money out. As Friedman points out, the effect is global, but global has local consequences. British police departments, for example, may have to be curtail patrols in their communities because they’re frozen out of their deposits in Icelandic banks.  “And therein,” says Friedman, “lies the central truth of globalization today: We’re all connected and nobody is in charge.”

Image from 1541′s photostream at Flickr and used under Creative Commons license.