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 â€“ 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 wonâ€™t. Yes we need to have
confidence that our money in our bank accounts is safe â€“ 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 isâ€¦an unprecedented capital market
failureâ€¦.not a cardiac eventâ€¦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 â€“ 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 wonâ€™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 wonâ€™t change until the deleveraging has played out and asset
prices stabilize â€“ 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 â€“ 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 ineffectiveâ€¦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 â€“ 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
possibleâ€¦but that is the price one pays to avoid another depression and
Can the Fed set credit or
the government spend borrowed money more efficiently than a functioning capital
market and private sector? Probably not â€“ 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 amokâ€¦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 â€“ 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.
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