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Forex Blog - Capital Market Failure Argues for Monetary and Fiscal Nuclear Option

Capital Market Failure Argues for Monetary and Fiscal Nuclear Option


I said from the get go that TARP was a down payment on the financial crisis or bank panic of 2008.  Indeed it was a down payment, a very small one, and with about half of the TARP depleted ($60bln left of the $350bln tranche), the Treasury will need to get Congress to release the second tranche or $350bln to throw more capital at the banks, insurers, credit providers (student loan, credit card firms, auto loan originators and trade financiers).  But all this effort is only keeping banks open – it put a kibosh on the panic, but does nothing to get banks lending and unless the Treasury and Fed (and FDIC) go into banks and hold a gun to the head of loan officers and CFOs it won’t.  Yes we need to have confidence that our money in our bank accounts is safe – ATMs will dispense cash and we can keep funds in money market accounts without direct government guarantees.  But no amount of money pumped into banks via the Treasury in Tier 1 capital or the Fed in liquidity changes the transformation underway in banking from investing as an extreme sport to investing as church sponsored bingo night.  Deleveraging is what it is all about and very clearly institutions (banks and near banks) are a long way from deleveraging.  Households and firms have only started to deleverage and this is at a time when employment and earnings are plummeting. 


I think it is high time for officials to call it for what it is…an unprecedented capital market failure….not a cardiac event…full on failure when no amount of therapy will revive the patient.  In other words banks see few incentives in taking risk or lending.  Unless you are a government entity or have the full guarantee of the government behind you, there is not a lot of money coming your way from the banks and in short order a lot less if you are among the lucky few who can get it.  Is that not what GE and Goldman did last month to get money from Buffet?   Highly rated firms with awesome track records forced to go begging for expensive funds.  If AMEX is becoming a bank to get access to cheap funds from the Fed and Treasury it is because the cost of funds in private market is not economical – or more like Goldman and GE not available.  A capital market failure in my book means the market is not an efficient allocator of capital and won’t be for the foreseeable future.


When the Fed and Treasury cheapen the cost of funds it is intended to incentivize banks and credit providers to borrow cheaply overnight and lend to households and firms at much higher rates.  But this process is broken.  Banks are going to the cheap funds trough but hoarding funds and buying risk free (government) assets instead of lending to households and firms, and much less other banks.  In other words there is no multiplier effect or credit expansion happening and this condition won’t change until the deleveraging has played out and asset prices stabilize – a life time in capital markets universe.  Moreover, the demand for credit is collapsing with the real economy.   And credit spreads are wide even with the improvement in LIBOR rates – corporate spreads over Treasuries, credit card rates, student loan rates, auto loan/lease rates and mortgage rates.  This is a Keynesian liquidity trap and traditional monetary policy is ineffective…even the Bernanke twist is ineffective (his own alphabet soup of DrainO programs).


What does a central bank and fiscal authority do in a massive capital market failure and liquidity trap?  Change course and deploy the nuclear option.  The nuclear option is to have the Fed buy assets directly from the market to drive market rates down in conjunction with a massive fiscal stimulus.   For the Fed this means quantitative easing (monetization or permanent increase in the money supply).  It may also mean that the Fed engage in credit expansion directly, lending to all sorts of entities including beleaguered auto companies that if allowed to fail set in motion an unacceptably high cost outcome in terms of employment, income and security.  Moreover, the Fed may need to extend loans to individuals for mortgages and purchases of durable goods that often require financing like automobiles.  For the government this means putting aside any notion of balancing the budget and diving head first into a fiscal stimulus mix of spending increases and tax cuts that could run into the multiple trillion dollar range and immediately.  The US economy is deteriorating quicker than nearly anyone alive has witnessed – if you are from an emerging country maybe you have seen it before.  Balancing the budget will have to wait and will require even more draconian tax hikes and spending cuts than anyone wishes and most think possible…but that is the price one pays to avoid another depression and deflation. 


Can the Fed set credit or the government spend borrowed money more efficiently than a functioning capital market and private sector?  Probably not – have to build some inefficiency into the policy response.  But short of the nuclear option left to its own the real economy will fail alongside the capital markets and the lucky few will be selling apples from a cart for a living.  Sadly the antidote to private sector run amok is public sector run amok…it is reversion to the mean.  As unfortunate the choices are the sooner they are adopted the sooner households and firms will have access to credit and government sponsored employment growth will check the private sector job losses ahead that threaten another wave of asset deflation and a very deep and lengthy economic contraction.  And if the nuclear option is chosen, then the sooner government can retreat to the sidelines and allow capital markets to return from the grave with a stronger and more dynamic regulatory architecture so that the banking panic of 2008 does not happen again. 


Yes I am suggesting a massive expansion in the deficit and outstanding stock of debt (replicated globally in due course).  Who buys it?  Sadly we all will – the Fed as it monetizes, private investors who fear any risky asset like a stock or corporate bond and global investors that see the US as one country that has a legitimate shot at pulling it off.  Budget deficits of $2-3trln are not out of the question and the overall debt ballooning to $14-15trln in the next few years can be absorbed without prompting the Zimbabwe outcome.  And the longer the nuclear option is put off the larger the cost of the eventual bailout. 


David Gilmore 




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