�The great inter-war slumps were not
acts of God or of blind forces. They were the sure and certain result of the
concentration of too much economic power in the hands of too few men (who) felt
no responsibility to the nation.� -- From the 1945 UK Labour manifesto, Let Us
Face The Future
There are signs that the credit crunch is easing. Interbank
lending in dollars has fallen for a ninth straight day. The various indicators
of stress in the market -- LIBOR, the TED spread, and the LIBOR-OIS spread -- are
all gradually returning to normal, but the damage to the broader economy has
Major corporations have had to stretch their credit lines
just to get the money they need to cover routine operating expenses and a lot
of retailers have not been able to get funding for their inventories for the
holiday season, so they�ll either have to hire fewer workers or simply shut
their doors for Christmas. Also, corporate defaults have increased as
businesses have been unable to turn over their short-term debt.
According to Fitch Ratings, the �crisis will cut growth in
credit this year by 50 percent as financial firms reduce leverage, investors�
appetite for risk declines, and the worldwide economy slows.� When credit is
less available, there�s less business activity and the economy slows.
Unemployment goes up and quarterly earnings go down. It�s a vicious circle that
starts with speculation and ends in panic. The financial system has to
reestablish its equilibrium by purging the excessive credit that developed
through low interest rates and lax lending standards. Financial institutions
everywhere are in the process of deleveraging which is putting downward
pressure on the main stock indexes and creating turmoil in the currency
The US Treasury and Federal Reserve are now underwriting the
entire financial system. The free market has been abandoned altogether.
Everything from commercial paper to money markets is now backed by the �full
faith and credit of the United States.� Without that explicit government
guarantee, the credit markets would still be frozen and the system would crash.
But government guarantees do not address the real problem,
which is toxic assets that must be accounted for and written down. All it does
is take hundreds of billions of dollars in mortgage-backed garbage onto the
nation�s balance sheet and undermine the creditworthiness of the United States.
Eventually, foreign central banks will see the folly of this maneuver and
refuse to buy more US debt. When that happens, there will be a run on the
dollar and a major dislocation in the bond market. Then, the financial system
will grind to a standstill once again.
Secretary of the Treasury Henry Paulson�s $125 billion
capital �giveaway� to nine of the country�s largest banks has helped to calm
the credit markets, but it won�t last. The �real economy� is beginning to
stumble and the stock market is gyrating more wildly than any time in history.
Wall Street is consumed with fear and investors are ducking out the exits as
fast as their feet will carry them. According to the New York Times, the banks
probably won�t even use Paulson�s money to extend loans to consumers and
businesses (as intended), but will hoard it to make sure they are sufficiently
capitalized when their mortgage-backed assets are downgraded. Even worse, the
banks may use the money to gobble up smaller local and regional banks.
On last Tuesday�s Jim Lehrer News Hour, New York Times
journalist Andrew Ross Sorkin put it like this: �The other thing that some of
them may do with that money is go out and make acquisitions and buy other
banks, (which) means that you will not be getting this money into your pocket
anytime soon. . . . I think the larger issue is the economy and these banks, in
terms of lending, are not going to start lending real money until the economy
Paulson knows what the banks are up to; after all, these are
his friends. The truth is, the $125 billion was not given to the banks to
soften the effects of the recession or increase lending. It was given to make
the strong banks even stronger so they could monopolize the industry. Paulson�s
real plan is �more consolidation� and less competition, or as economist Michael
Hudson says, �Big fish eat little fish.� The Treasury secretary is using his
authority to reward his friends rather than doing what is best for the country.
In the last few weeks, the broader economy has deteriorated
faster than any time in the last 70 years. That�s why Fed chief Ben Bernanke
has given the nod to another stimulus package of $150 to $300 billion dollars.
The gears are rusting in place and the desperation in Washington is palpable.
Calculated Risk web site provided a transcript of a conference call by MSC
Industrial Supply (MSC) which summed up the prevailing mood in today�s business
MSC: �In the last several weeks, customers� sentiment has
turned dramatically downwards. Here are a few of the things we have recently
heard and I�ll quote a few of them. One quote is our new orders are down
substantially in the last few weeks. Another is that corporate has told us to
reduce inventory. What we have also heard is make due with what you have. And
finally, another quote is capital expenditures are on hold. Customers are
concerned about the economy and the lack of available credit. They�re reducing
inventories, orders, and order size and there has been a trend toward deferring
capital expenditures . . .�
MSC: �David, we view this time as unprecedented in history.
The economy is undergoing a huge change, how that is going to shake out all
remains to be seen, but I think what is important to know is it�s a huge change
that, frankly, no one had a chance to see coming, so we than specifically in
our customer base there is a tremendous amount of fear that is gripping
customers and evidenced by what we have seen the last couple of weeks in
October, almost buying paralysis, that is really the way that we think about
it, and frankly, in speaking with so many customers what we see happening. . .
. What is has happened here with the credit crisis is while the economy was by
no means booming, it was kind of rolling along and we almost think that what
typically would have taken six, seven, eight, 9, 12 months to start to come
down happened almost literally overnight.� (Calculated Risk)
Events are now unfolding so quickly, they�re impossible to
follow. But this much is clear, the wheels have fallen off the cart. The Fed
has lost control of the system. Last Monday, Bernanke announced the creation of
the Money Market Investor Funding Facility (MMIFF), which will provide $550
billion in liquidity to U.S. money market investors. It is another in a long
list of steps to try to provide liquidity to a system that is burning through
trillions of dollars of credit via the deleveraging hedge funds and asset
downgrades. Of course, the Fed does not really have the money it has committed.
It will have to expand its balance sheet, issue more Treasuries, and hope that
foreign central banks do not see that the US financial system is headed for the
�It is essential we preserve the foundations of democratic
capitalism,�� Bush bellowed last Monday.
All that�s left of the free market is the threadbare
rhetoric of our lame duck president. The world�s biggest debtor is now the most
ardent defender of market fundamentalism.
Last week, banks borrowed a record $437 billion per day,
topping the previous week�s $420 billion per day a week earlier. Hundreds of
banks cannot meet their capital requirements without regular low interest loans
from the Federal Reserve. The banking system is in shambles. The FDIC needs to
determine which banks can be saved and which need to be shut down, otherwise
the insolvent banks will use the money they get from the Treasury on risky bets
to dig their way out of bankruptcy. Without restrictions on how they can issue
credit, many of the banks will engage in the same reckless behavior and
speculation that brought on the current calamity.
Ninety-two-year-old Anna Schwartz, who co-authored �A
Monetary History of the United States� with Milton Friedman, said in a recent
Wall Street Journal interview that Paulson and Bernanke �should not be
recapitalizing firms that should be shut down.� Rather, �firms that made wrong
decisions should fail. . . . By keeping otherwise insolvent banks afloat, the
Federal Reserve and the Treasury have actually prolonged the crisis.� At the
same time, they have not alleviated the uncertainty among lenders �that
would-be borrowers have the resources to repay them.�
This is the very heart of the matter; the distrust will
remain until the bankrupt institutions are shut down and confidence is
restored. The good banks have to be strengthened, the bad banks have to be
closed, deposits have to be insured, foreclosures have to be reduced (to
stabilize home prices), and consumers need immediate stimulus (including food
stamps, extended unemployment insurance, infrastructure spending and aid to
states) to rev up the economy. All of these have to be done as quickly as
possible to avoid further damage to the economy and greater personal suffering.
According to an estimate by the UN�s International Labour
Organisation (ILO), �Twenty million jobs will disappear by the end of next year
as a result of the impact of the financial crisis on the global economy . . .� Construction,
real estate, financial services, and the auto sector are most likely to be hit,
according to the ILO�s estimate which is based on International Monetary Fund
projections for the world economy. It could be worse if the Bernanke and
Paulson botch the rescue.
The FDIC�s Sheila Bair has been the one �bright light� in
the present financial train wreck. She has done a first-rate job of closing �sick�
banks and renegotiating mortgages. Last week, Bair blasted Paulson for focusing
all his attention on the banks and financial institutions instead of
homeowners, many of who are now facing foreclosure. In an article in the Wall
Street Journal, she said. �We�re attacking it (the crisis) at the institution
level as opposed to the borrower level, and it�s the borrowers that are
defaulting. That is what�s causing the distress at the institution level . . . So
why not tackle the borrower problem?�
Unlike Paulson, Bair seems to grasp that the hemorrhaging in
the financial sector cannot be stopped unless the rate of foreclosures is
slowed and housing prices stabilize. The FDIC chief has taken a sensible
approach to the crisis by writing down the face value of mortgages and putting
homeowners in conventional 30-year fixed rate loans that make it possible for
them to avoid foreclosure.
According to Bloomberg, �[Bair] now has the authority to
offer loan guarantees that could encourage modifications by mortgage-servicing
companies in an effort to avert foreclosures. The new financial rescue plan �allows
the government to set standards for mortgage changes and offer guarantees for
loans that meet the standards.� This gets to the root of the larger problem
which is stopping the slide in housing prices so that the mortgage-backed
securities market can normalize.
The actions of the Fed, the Treasury and the FDIC are likely
to cost in excess of $2 trillion. That does not include the trillions in market
capitalization that are wiped out by plummeting home and stock prices. Nor does
it include the incalculable suffering from rising unemployment, falling living
standards, or personal hardship. Eventually, the Fed�s emergency measures will
result in higher taxes, soaring deficits and slower growth. As America�s �consumer-based�
economy flags and the recession deepens, capital will flee US Treasuries and
securities and create a funding crisis. This may be hard to imagine, now that
the dollar is strengthening and US Treasuries appear to be in great demand, but
the handwriting is already on the wall.
Brad Setser explains the dollar�s surprising reversal in his
latest blog-entry: �The dollar�s rise since July is part of a reversal in
longstanding investment trends that prevailed during years of plentiful
borrowing, strong growth and low financial-market volatility. �Essentially,
every large trade that built up a head of steam in the go-go years has blown up
or is in the process of blowing up,� wrote Alan Ruskin, chief international
strategist at RBS Greenwich Capital, in a report to clients. �That goes for
almost every asset class.��(Brad Setsers Blog)
The recent surge in US Treasuries is also misleading, much
of it having to do with terrified investors that are dumping their shares in
stocks, mutual funds and hedge funds for the perceived safety of US debt.
Foreign investors, however, seem to be losing their enthusiasm for Treasuries
as America�s future continues to darken.
The net foreign purchases of long-term securities in August
was a mere $14 billion following an even more dismal $8.6 billion in July; not
nearly enough to meet $55 billion per month the US needs to balance its
consumption of foreign goods. Even worse, the purchases of long-term US
securities �went negative� for foreign private investors (by $8.8 billion),
which means that the dollar is being artificially propped up by foreign central
banks to avert a disorderly unwinding of the currency.
Foreign investors and central banks are no longer providing
the capital to support the US $700 billion current account deficit. They have
lost confidence in America�s ability to bounce back from the credit crisis
which has swept through the financial system and is now hammering away at the
broader economy. That means the demand for US debt will fall and the prospect
of hyperinflation will grow. Even if the dollar is able to weather the storm
ahead (and the nation can avoid a funding crisis) the massive deficits brought
on by Bernanke�s �emergency� spending spree will force interest rates upwards
and tighten credit even more.
As Michael Panzner, author of �Financial Armageddon� says, �While
the U.S. may not suffer from a funding crisis in the immediate future, the
voracious money-raising appetite will make life much more difficult for the
private sector, in the sense that, they will be �crowding out� increasingly
desperate borrowers who will find their options are more and more limited.�
The Fed now faces the daunting task of trying to maintain
America�s dominant place in the global system while the economy contracts,
deficits skyrocket and the pillars of US-style capitalism come crashing to
Whitney lives in Washington state. He can be reached at firstname.lastname@example.org.