The Ultimate Greenspan Put ...

We should not bother summarizing the facts;

still we will. During the last seven months the Federal Reserve Bank of the United States has pushed the

Federal Funds rate (FFr) to negative real values; it is now offering American banks

to swap risky securities of uncertain value for safe Treasury securities of

certain value, while at the same time engineering the acquisition of one bank by another. The bi-partisan "federal stimulus" plan is currently underway: American

taxpayers are being mailed checks of varying amounts, the total value of

which is about 1% of GNP. The question we ask is: does the whole package of

government interventions make sense, given the nature of the crisis? Apparently, it does: most commentators are

applauding the choices, and the few people uttering criticisms are mostly

anti-market types used to blame free markets, competition, capitalism and

globalization for everything painful, from financial crises to diarrhea. Among

experts, the unanimous consensus is that these choices are the correct ones. We

dare to disagree. Today we illustrate the reasons for our disagreement; next time we discuss alternative policies.

There are three parts to the overall

policies adopted: the fiscal giveaway, the cut in interest rates and the asset

swap. Let's consider them in turn.

Fiscal giveaway. This is receiving scant

attention as most people discount its electoral nature. Too bad because, until

now, the fiscal stimulus is the most expensive arm of the three-pronged

government intervention strategy. Increasing the disposable income of about 90%

of American households of about 1.5% will make no difference on defaulting mortgages, but increasing government debt does signal that the strategy of getting out of financial troubles by piling up new debt is not yet over. Nobody - but Paul Krugman: GWB and PK are, for once, on the

same side - claims that the impending recession is due to a sudden drop

in aggregate demand. If anything, the crisis is due to a prolonged excess demand

for housing fueled by an extraordinary amount of cheap credit made available by the Fed, which pushed up housing prices past the level a sizable fraction of

American households could afford, given their current and expected nominal incomes. In other words, the current crisis is due to a "localized asset-inflation" generated by reckless central bank lending, and its magnification through "moral-hazard-plagued" financial innovations from the banking sector. Because the nominal prices of a number of real and financial assets are completely unrelated to their future payoffs - and because nominal income is too low to provide the resources needed to serve the debt those assets were purchased with - something must give. Either the nominal values of those assets drop - via asset deflation and bankrupcies - or nominal income grows extremely fast - via generalized inflation.

The bursting of the bubble that localized asset-inflation brought about is causing a sharp slowdown of real economic growth. This happens because the realization

that prices had gone passed the level "would be" buyers could

afford took place after the production

of the houses had already been completed or, at least, had started. The

resources so invested are therefore wasted: they produced goods people do not

want or cannot afford; hence the owners of those resources are receiving compensations that are much lower than they expected. From this the recession:

assets must be devalued and resources (factors of production) must move away

from the unwanted/unaffordable goods and toward goods that households and firms

both want and can afford. Even assuming that the increase in purchasing power

the fiscal giveaway is supposed to produce will not be washed away by an

increase in prices of the same proportion, it is certainly not by raising

aggregate demand for burgers, shoes, or airplane tickets of about 1% that such

reallocation of resources will become less painful. More important: the giveaway

will do nothing to reduce the impact of the financial crisis brought about by

the real estate crisis. This is due to the fact that a fraction of American

households cannot afford the houses they bought, and are defaulting on mortgage

payments; the banks holding the loans are therefore making losses. For a

household defaulting on a $200K-500K mortgage, a once in a lifetime $1,000 of

additional cash will make no difference. Bottom line: the fiscal giveaway cannot alleviate either the financial crisis nor the recession; it will only add a bit to the CPI.

Interest rate cuts. Since the Greenspan's years

the fashion has been to measure the result of such interventions by subsequent

movements in the stock market. Assurances to the contrary by local Feds' presidents not-withstanding, this has now become the way in which financial markets, and economic agents at large, interpret and evaluate Fed's actions. Because the current Chairman of the Board of the

Fed has actually written papers trying to measure how market indices react to

unexpected Fed's actions on rates, this common wisdom has been recently reinforced by actions such as the one on January 22, 2008; i.e.

that the Fed should move interest

rates to prevent the stock market from falling. There are absolutely no reasons

to believe this makes any economic sense, nor the mandate of the Federal Reserve

system is that of keeping stock market indices growing at some target rate. The

ECB, wisely in our view, is basically ignoring the stock markets in its policy

actions: price stability is its goal, not capital gains. In any case, if we had

to judge the success of the Fed's policy by this metric, the verdict would be

damning. During the last six months the Fed has cut rates six times, two of

which could be reasonably considered "surprises". Stock valuations are about 15%

lower than six months ago and they display no intentions of recovering in the

near future. The only effect these cuts seem to have had, so far, is to increase

volatility: relatively large "rallies" on the day of the announcement or the

next one, followed by even larger drops right after. The proposition that the

Fed is moving short term rates to affect stock prices - and that it actually has

the power to affect stock's real valuations more than ephemerally - rests on the idea

that movements of the short term rates can affect either the perception (in

which case: for how long?) or the reality of aggregate risk. This is a very long

shot, which goes well beyond the usual "output-inflation trade-off" kind of

arguments and for which there is practically no theoretically

consistent support, let alone favorable empirical evidence. How a sustained reduction in

aggregate risk may be engineered by a 300 basis points drop of the FFr, escapes

us. Unless, obviously, one is willing to believe the asset bubbles of 1997-2000 and of 2002-2006 - with the accompanying academic chatters [references piteously omitted] of "reduced volatility", "reduction of aggregate risk", "great moderation" and "higher assets evaluation" - were good things that the reduction of aggregate risk engineered by a lax credit policy brought us. Hence - even if the last ten years of US central banking may lead one to

reasonably suspect that this was one of the motivations behind his predecessor's

actions and that Mr. Bernanke is now forced to cope with the wrong expectations

Greenspan created - we dare to assume this was not the purpose of Bernanke's

recent choices.

A more realistic purpose may be that of

stopping the growth in mortgage interest rates caused by the post-2004 Fed's

policy. This is widely regarded as the pin that pricked the bubble the 2001-2004

policy of persistently low FFrs had previously created. As this is not the right

moment to argue over the details of what caused what (one day or another it should be, though)

let's leave this issue aside and consider how successful this policy may be. A

reasonable argument is the following: a raising FFr increases both short and

long term market rates. Because a sizable share of mortgages is financed with

adjustable rates that are being reset after a few years on the basis of short

term rates, this is causing the increase in default rates we are all the victims

of. How do we stop the bleeding that defaulting mortgages are causing?

Increasing borrowers real income by 10-15% is impossible, so let's try to lower

the amounts they must pay. If we lower the FFr enough, mortgage rates

(especially those on ARMs) should also go down, therefore alleviating the

mortgage crisis. Right? Possibly, but not necessarily. Resetting does not take

place continuously, but at fixed time intervals that, sometimes, are as long as

one or two years. Hence, at least for a year after the FFr cut, no interest rate

relief may possibly be forthcoming to borrowers: those that were defaulting

during summer of 2007, still will, and those for whom resetting was due during

the last six months are facing the same higher rates. Further, the market rates

on which ARMs reset are not necessarily responding one-to-one to movements in

the FFr (even when it comes to nominal short term rates the Fed is NOT

omnipotent) and in fact they are not. They have gone down, but not as much as

the FFr has. In other words, while lowering the FFr may appear to be a source of

relief for troubled borrowers, it is clearly not quantitatively very

significant. The Libor or the 1-year costant maturity Treasury rates have

declined, but the risk spread has increased of about as much on both of them,

thereby improving the situation only mildly and certainly not in the immediate

future. Finally, and more importantly, mortgage rates are now at the same level

(sometime higher than) they were a year ago, hence no chances of obtaining an

advantageous re-financing deal thanks to the Fed lowering of the FFr.

Refinancing at a lower rate, or switching from the risky ARMs to the less risky

fixed rate loans, would be the desirable and natural solution for most troubled

borrowers, but this solution seems to be out of question for the time being. In

summary, while theoretically this channel could have a positive impact on

the causes of the financial crisis, practically its impact is quite

limited: it does not do damage, but it provides very little help. More

importantly: maybe this is not too little (rates are down more than 300 basis

points, after all) but this is certainly way, way too late. Which leads to the 100 trillion dollars question:

what on earth is or was the economic justification behind the wild interest

rates roller coaster of 2001-2008?

There is a third purpose for cutting the

FFr: the Phillips curve, the inflation-output trade-off, the dream that never

dies. Because, among macroeconomists and monetary theorists, this has become

more a matter of faith than of rational discussion, there is little one can say.

In our view the experience of 2000-2001 and the current one (not to speak of

1991) show that the Fed has no practical ability whatsoever to avoid a recession

by lowering short term rates: whatever the forces causing the recession may be, once

the Fed's thermometers signal its presence a recession is already underway.

Models based on the assumption of rigid prices (the absolutely essential

ingredient necessary to claim that a rate cut has at least a chance to prevent a

recession) keep failing the quantitative test: no one has been even

remotely able to produce a vaguely realistic set of parameters under which the

"inflation-output trade-off" is of any quantitative importance and can be

exploited by Fed's actions. The kind of price rigidities needed to make the

trade-off empirically exploitable through interest rate cuts are of the order of

2 or 3 years: every American (or European, or Chinese, or Mexican) consumer,

facing prices that change weekly if not daily, would find such a

statement laughable. Still, most macroeconomists, especially those working at

the banks of the US Federal Reserve system, take it very seriously: they must be too

busy writing monetary models of price rigidities to afford the time to go shopping. One cannot avoid

mentioning the irony of a theory claiming that rigid prices are the cause of

this recession and that the latter will be cured by lowering nominal short term

rates, when the recession is due to house prices falling too quickly and

commodity prices rising too abruptly, following the bursting of a bubble

engendered by ... excessive lowering of nominal short term rates!

Summing up: any visible success?

Apparently not. As far as we can tell, the only thing that the Fed's policy of

precipitously cutting rates has achieved so far is to scare the public opinion,

making consumers even surer than they would be otherwise that a recession is

coming and that all hell may break loose sometime soon. But, maybe, the effects of the lower

interest rates policy will be visible in the future months, or in a year. Maybe,

if the Fed had not lowered interest rates so much and so rapidly, things would

be already worse. That is true, maybe. But one should observe that the ECB has

not followed the Fed in its policy of cutting rates, and things in Europe are

not going so differently than in the USA; if anything, they are going slightly

better. Stock market indices oscillate up and down in the midst of a generally

negative tendency, but they are less down than in the US; some countries, Spain

possibly and Italy almost certainly, are heading toward a recession, but the

first had been growing briskly for 14 consecutive years while the second is

becoming Argentina, so it does not count. This does not mean things look alright

in Europe; it simply means that, even six months later, having dramatically

lowered interest rates by 300 basis points does not make much of a

difference either for the real economy. To us this suggests it is about time to look somewhere else.

The asset swap. No one seems to be claiming that

the TSLF and the PDCF have been set up to alleviate the recession

by exploiting the output-inflation trade-off. They have been set up, we are

told, to save the banking and payment system from a systemic crisis, the "domino

effect", the collapse of the American, hence the world, financial system.

Really? First off: the total value of US Treasury securities in the hands of the

Fed was, at the inception of the crisis, 3/4 of a trillion dollars; it is

now quite a bit less. At their opening, the two facilities have about $400

billion of Treasury securities available, max; in practice they have about $200

billion. As of March 23, the nominal value of just the Credit Default

Swaps outstanding had passed the $40 trillion mark; JP Morgan and Citi together

hold more than $10 trillion. Hence, if the words "domino effect" or "systemic

crisis" are meant to describe things like "the market for CDS unfolds" because

"bankers confidence" collapses, then TSLF and PDCF are like trying to save New Orleans

from hurricane Katrina by telling people to open their umbrellas. If Citi alone

becomes unable to serve its portfolio of CDS, the two facilities will be blown

away immediately. In other words, IF the theorists of the "domino effect" mean

what they say, THEN they better get ready for an overall nationalization of the

US banking system. And, we add, IF that is the scenario the Fed has in mind, THEN it better starts doing something different from lending money to

investment banks in exchange for pieces of paper of the uncertain value. On the other hand, IF "preventing the domino effect" is just another name for "keeping the guys on Wall Street afloat" without letting the citizens know, THEN the two umbrellas

are just fine.

Next argument: the "domino effect" works

in steps, so it is the apparently small collapses that must be avoided as

they trigger bigger and bigger ones. For the dominant wisdom the counterfactual

is obvious: IF lenders had not known that the Fed was going to engineer the JP

Morgan purchase of BSC (thereby bailing out all its creditors), THEN the systemic

crisis would have happened. No one can contradict such a counterfactual, hence we will not try. We note, though, that while the BSC crisis was unfolding

there was no sign whatsoever of a run on the other banks (investment

or not), or of symptoms of panic among depositors. The Fed has

brokered a good deal for a bank with the justification of avoiding the collapse

of another, and the consequent "domino effect". The "collapsing" bank is

currently worth about $1.5 bn, and the quotation of the acquiring entity has

gained about 20% since the deal was announced. Why on earth a central bank

should meddle in this kind of private business

escapes us completely, so let's leave it at that and return to the common wisdom counterfactual. There were, it is true, talks about Lehman and Goldman&Sachs being the next ones on line, which would not have been nice for the people there, and probably at a number of other places. Nevertheless, a couple of days later both banks engendered a (temporary) banking rally by showing numbers proving they were better off than expected. Is it too much to ask: what's preventing most or all "banks" from doing so? In fact, this seems to be, if not a 100 trillion dollars question, at least a 10 trillion one: the sub-prime mortgage crisis is now more than a year old, why is it that the Fed and markets' regulators still seem unable to have the banks' information disclosed and portfolios "marked to market" in any reliable sense? If it is "fear", "lack of trust" and generalized "asymmetric information" (normal people call them "lies" or "tricks") that prevent the markets from working and that repeatedly dry up liquidity, should we not have started a year (or more) ago to tackle THOSE problems?

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Furthermore, we

are told, we must avoid a repeat of Japan in the 1990s. Really? We will get back

to the historical analogy later; now let us consider more solid rationales behind the

asset swap policy. We understand it is not fashionable to talk about moral hazard these days, as moral hazard is just a theoretical concept practically minded policy-makers wipe off the table whenever the goings get tough. A "practical" and very "tough man" style argument (championed, together with the whole of Wall Street, by Lawrence Summers) is that the financial system stability and health is way more important than some deological argument about moral hazard and reputation, the relevance of which is negligible in dramatic circumstances such as these. As Craxi explained the Italians, while he was siphoning a good percentage of GNP in his and his friends personal accounts, primum vivere, deinde philosophari ... and in front of two expert authorities of such caliber, all we can do is to bow. Nevertheless, we would like to point out that what has happened since 2002 and has got us in this mess IS exactly what the "theoretical" moral hazard argument would have predicted in front of current Fed's policies and the "too big to fail" doctrine. Moral hazard, in other words, is not just a theoretical argument: it is a sad fact of business life, especially around Wall Street. A point in time must exist at which a country decides to bite the bullet and let the incompetent, or just plain fraudulent, companies fail to establish a minimum of reputation and avoid fraudulent behaviors in the future. Apparently, that point in time has not yet arrived for the USA, so let's just remind everyone of the open wound, an move on.

We hear that the asset swap is justified if one

believes the assets that are troubling the major investment banks now will have

more value soon. Call it Scenario 1, and say it is just a liquidity problem: the

investments were sounds or almost so, but there is cash due out in the short run,

which was not expected, and therefore the sound investments need to be kept

alive by the Fed acting as the FDIC of investment banks. [For the well trained:

think of Diamond and Dybvig JPE-1983 on a gigantic scale. Kiyotaki&Moore-like arguments would not work, for a variety of reasons we would be happy to discuss if the comments require it.] We don’t see any

reason to believe this is the most probable scenario - why? Obvious: if they were good investments, why

would mortgage holders default and lenders refuse to recontract on houses that

will eventually become worth owning/financing? Recontracting is NOT forbidden,

so why are not the two parts coming together and finding a way to reap the

future gains? - still, we will pretend it is for the sake of the argument. The

other possibility (call it Scenario 2) is that we are all collectively dreaming

this will be the case: even in months to come the so-called assets will still be

almost worthless pieces of paper. Or, at least, many of them will still be.

Then, two possibilities arise from the current Fed bailouts/asset

repurchase/fund of banks creation, and so on.

Under Scenario 1, by avoiding marking to market those assets,

as financial institutions should currently be doing, the bailouts put off the

$1-trillion-worth estimated losses (see Goldman Sachs' own analysis; CNN.com reports 500 billions in losses for mortgages

alone) to a later date, hoping that these will in the end be less.

In

fact, the Fed is betting to be able to "create" Scenario 1, instead of taking

the scenarios as exogenously given. The downfall can be avoided if the market

(that is, at least someone out there) insists in believing they are worth more:

we restore "confidence". By the way, no theoretical model can explain how this

change in expectations occurs, other things equal. In other words, Scenario 1

makes sense if and only if we are willing to believe that the Fed has superior

forecasting and evaluation powers, so that it can see future gains where the

whole set of participants in the financial markets cannot. Is this possible? It

is, in the abstract this is quite possible. Is it probable? History and economic

theory suggest it is not, still let us assume it is. If we assume it is, that

is if we are ready to believe that the Fed is capable NOW to evaluate the prices

of assets better than the financial markets can and, by holding them for some

time, increase their value in the near future, we should be ready to explain why

it was not able to do the same in the PAST, or 2 years from now. Put

it differently: if we believe Scenario 1 is what makes the asset swap a good

idea, then we must be ready to explain not only why the Fed screwed it up so

royally during the last twelve years but why we should not have let the Fed set

prices of financial assets during those years! Paradoxes? Indeed, paradoxes they

are. More importantly, because bygones are bygones we should also ask: under the

maintained assumptions, what prevent us from concluding that, in the future, it

will be the new job of the Fed to set the prices of assets and decide which

financial institutions should hold them, and which should not? Once again, and

for different reasons, we reach the same conclusion as before: IF what the Fed

is doing makes sense THEN we might as well consider nationalizing the whole

financial sector and let the Fed run it.

Under Scenario 2, however, that’s Japan in the

1990s, instead of its opposite. The Fed

intervenes now to avoid for these banks to at least partially acknowledge today

the losses that are there and that will never go away. In other words, the Fed

intervenes to purely push into the future the day of reckoning, in exactly the

same way the Bank and the Government of Japan did after 1990. Western

commentators, economists, bankers, and even government officials, very much

criticized that choice back then, and invited the Japanese central bank and

government to stop acting in the very same way the Fed and the government of the

US are acting today. We all pointed out that these actions result in freezing

funds, slowing credit growth, keeping alive firms that are dead, and giving rise to

a gigantic "liquidity trap", as failing banks were kept afloat by feeding

them new credit over and over, credit they never invested or used productively.

They simply sat on their reserves, doing nothing and postponing a death that

would eventually come. In the meanwhile, economic activity slowed to a dramatic

stagnation that lasted almost a decade. How will Scenario 2 end? By slowly

bailing out various banks, which will cost all of us a lot of money, during a

very long credit market clog that will lead to a very long stagnation. Do you

believe that the artificially created liquidity trap that paralyzed Japan for so

many years will not happen in the USA? Think again, apparently it is already

here, the FT reports.

These are the only scenarios under which

the Fed's policy of swapping bad assets for good treasury securities makes

sense, so to speak. Right now the only ones ready to believe Scenario 1 are the

Wall Street bankers, the Fed and, perhaps, other central banks. To convince others that pieces of paper

are actually gold, avoiding the credit clog and the Japan effect, something more

than "convincing" has to be done. And that's what the Fed is doing: transferring

possession of assets to itself to deflect counterparty risks, which implies

buying at fictitious prices the pieces of paper, which implies changing the

price of money and Treasuries by changing their supply. Which means, at the end,

charging the $600-1,000 billion of real estate market losses to the taxpayer,

either directly or indirectly. The bottom line is obvious: there's no new-school

change in expectations, but an old-school change in demand and supply of goods and money, and we

ALL have to be ready to pay its big price tag: exchange rate depreciation, inflation and a probably longer stagnation or recession. The inflationary cost we are already paying through dollar

depreciation and commodity price hike that are translating into CPI inflation. For the long stagnation we will have to wait long.

We don't know you people, but we prefer

adjusting relative prices by reducing the value of housing (and of these pieces

of paper) soon, rather than increasing the price of everything else and then forfeiting economic growth for a few years to come.