Memo to Bernanke: Enough with the rate cuts, already!
By Mike Whitney
Online Journal Contributing Writer
Apr 24, 2008, 00:20
Last week's stock market blowout added more than 4 per cent
to the Dow Jones Industrials, but it had no affect on Libor rates.
Libor rose steadily from Tuesday through Friday signaling more
troubles in the banking system.
Libor, which means London Interbank-Offered Rate, is the
rate that banks charge each other for loans. It has a dramatic effect on nearly
every area of investment. When the rate soars, as it did last week, it means
that the banks are either too weak financially to lend to each other or too
worried about the ability of the other bank to repay them. Either way, it puts
a crimp in lending. Banks serve as the transmission point for credit to the
broader economy via business and consumer loans. When they're bogged down by
their own bad investments or when risks increase, rates go up, lending
slows, business activity decreases and GDP shrinks. It's a vicious circle.
The sudden surge in stocks is not a sign that things
are back to normal, far from it. If anything, things are worse than ever.
Credit remains unusually tight despite Bernanke's cuts to the Fed Funds
rate or the creation of various �auction facilities� that remove mortgage-backed
securities (MBS) from banks' balance sheets. Businesses and consumers are still
having a hard time getting funding, which means that the velocity of money in
the financial system is decelerating rapidly and this increases the likelihood
of a system-wide freeze-up. Libor is just the flashing red light.
A rise in Libor adds billions in additional interest
payments for homeowners, businesses and other borrowers.
According to the Wall Street Journal, �Libor is one of the
world's most important financial indicators. It serves as a benchmark for $900
billion in subprime mortgage loans that adjust -- typically every six months --
according to its movements. Companies globally have nearly $9 trillion in debt
with interest payments pegged to Libor, according to data provider Dealogic.�
Commercial real estate deals are mostly pegged to Libor as
are adjustable rate mortgages (ARMs). In fact, most of the mortgages that were
written up during the boom years were tied to Libor. That's why Peter
Fitzgerald, chief financial officer at Radco Cos., said, "If Libor were at
4 per cent instead of under 3 per cent, there would be a disaster that would
take years to unwind.� (WSJ)
A rising Libor puts the Fed and the Bank of England (BOE) in
a tough spot. They're trying to keep rates artificially low so the banks
can increase their lending and recoup their losses, but the market is not
cooperating. The market is driving Libor upward, which means the Fed is losing
control. The real cost of money is going up.
The Bank of England was forced to intervene on Monday.
Mervyn King, the UK's central bank governor, launched a �Special Liquidity
Scheme� to �improve the liquidity of the banking system and raise confidence in
financial markets while ensuring that the risk of losses on the loans they have
made remains with the banks.� The plan will provide $100 billion for
"illiquid assets of sufficiently high quality� (Mortgage-backed
securities) to �unfreeze� bank lending. The plan is similar to the Fed's
auction facilities which have provided over $200 billion in exchange for dodgy
MBS, collateralized debt obligations (CDOs) and commercial paper (ABCP)
According to Bloomberg, �The Central Bank�s move allows
financial institutions to add government bonds to their inventory of liquid assets
and make it easier for them to raise cash and lend, especially to consumers
seeking home loans. In return the government will hold the riskier
The Bank of England said the swaps would be for a period of
one year and could be renewed for up to three years, although the banks would
be on the hook for losses on their loans. It�s a sweet deal for the investment
banks and a total loser for the British taxpayer who could get stuck with
hundreds of billions of worthless MBS.
The $100 billion liquidity injection is the biggest bailout
in the bank�s history, and it was granted without public input or parliamentary
authorization, just like the Bear Sterns transaction. The bankers call the
shots while the public picks up the tab. The bank�s action puts to rest the
idea that �the worst is behind us.� It isn't; in fact, recent estimates
suggest that the losses to the banking system could exceed $1 trillion.
There's still a lot of carnage ahead.
The $100 billion will
help to stabilize the money markets and put the banks on sounder footing,
but it does nothing to help the housing market. The British real
estate market is on life support because most of the mortgage financing was
coming from investors who bought MBS. Mortgage securities are currently down 92
percent from the same period last year, which leaves potential buyers without a
funding source. The BOE is considering creating a British-style Fannie Mae
to kick-start the stalled housing industry by providing government-backed loans.
The private sector will not be a big player in the housing market for the
The same is true in the US. If the Fed can't bring
Libor down with interest rate cuts, then it will have to develop
a back-up plan. The next step would be �quantitative easing,� a
monetary policy that was implemented by the Bank of Japan in 2001 �to revive
that country's economy that was stagnant for a decade. Quantitative easing
entails flooding the banking system with excess reserves, resulting in pushing
the benchmark overnight bank lending to zero.� [Reuters] There are indications
that Bernanke is already preparing for this radical option, but there's
little chance that it will succeed.
Whether the banks are able to lend or not is irrelevant.
Public attitudes towards indebtedness have changed dramatically in the past few
months. Overextended consumers are looking for ways to pay off
their debts. This will make it more difficult for Bernanke to reflate the
equity bubble through credit expansion. When people are frightened or
pessimistic about the future, they naturally curtail their spending.
A recent poll conducted by the Washington Post/ABC
illustrates how the public�s attitude towards the economy has darkened
in a matter of months. According to the survey, �Nine out of ten Americans
now give the economy a negative rating, with a majority saying it is in 'poor'
shape, the most to say so in more than 15 years. And the sense that things are
bad has spread swiftly. The percentage who hold a negative view of the economy
is up 33 points over the last year, and the percentage who rate the economy
'poor' has increased 13 points in the last two months. That is the quickest
60-day decline since the Post and ABC started asking the question in 1985�
The average American is showing a better grasp of the
deteriorating economic conditions than the stock market. Housing sales continue
to tumble, manufacturing is off, unemployment is steadily increasing, retail
sales are flat, and inflation is soaring. Consumers are feeling the pinch of
rising food and energy costs, loss of home equity and a general downturn in the
credit markets. Money is tight and jobs are scarce.
Are you better off today than you were eight years
When George W. Bush took office in 2001, oil was $28 per
barrel, the euro was $.87 on the dollar, gold was $274 per ounce. Today, oil is
a record $118 per barrel, the euro is nudging $1.60 on the dollar, gold is $945
per ounce. The country is presently engaged in a $2 trillion war in Iraq with
no end in sight. The federal government has expanded over 30 percent under
Bush. Wages for working people have stagnated, unemployment has risen, 47
million Americans are without health care, and the economy is slipping into
Now the banks are buried beneath a mountain of bad
investments and foreclosures are at record highs. In California, 65,000 homes
are now in some stage of foreclosure while the total number of homes sold in
February -- new and old -- was a mere 20,513.
The knock-on effects of the housing bust are just now
rippling through the broader economy. Consumer spending is sluggish, growth is
weak, and the stock market is more volatile than anytime since the 1930s. The
Fed has usurped congressional powers to deal with insolvency problems at the
banks. Public money is now being provided for the purchase of dubious assets
held by unregulated investment banks owned by private speculators. The Fed is
simply making up the rules as it goes along. Bernanke's actions
have not yet been challenged by any congressman or senator.
The Fed's monetary policies have triggered a run-up in
commodities prices, which is driving up the cost of everything from corn to
copper. Food riots have broken out in capitals around the world and leaders are
worried about growing political instability. The media are blaming drought,
high energy prices, and biofuels for the sudden rise in prices, but these are
only secondary factors. Currency devaluation has played a bigger role than
shortages or blight. The world is awash in dollars which are steadily losing
value. Pension funds and foreign central banks are diverting dollars into
commodities rather than keeping them in corporate bonds or the sagging stock
Here's an excerpt from the Wall Street Journal that sums it
up: �Inflation is rising throughout the world due to dollar weakness, and the
prices of such commodities as oil and corn have soared. . . . As former Fed
Chairman Paul Volcker noted last week, we are already in a 'dollar crisis.'
Even the IMF -- typically the temple of devaluationists -- is alarmed by the
dollar's fall. Dollar weakness has already contributed to soaring commodity
prices that have walloped US consumers just when their spending is most needed
to offset the housing slump. . . . The commodity boom is result in large part
of the Fed's weak dollar policy, and it may have tipped the US into recession
that could have been avoided.� [Wall Street Journal]
Foreign banks and investors currently hold $6 trillion in
dollar-based assets and currency. When the dollar falls, speculation will
increase and prices will rise. Currently, the US is exporting its inflation and
fueling political unrest in the process. If Bernanke continues to slash
interest rates, the problems will only get worse. The Fed could raise rates by
50 basis points tomorrow and the commodities bubble would explode overnight,
but that doesn't look likely.
The idea that soaring commodity prices are the result
of speculation is controversial. The economist Paul Krugman does not think that
�low interest rates and irrational exuberance� are responsible for the high
prices. Rather, he thinks they are the result of �rapidly growing demand and
constrained supply.� This is certainly possible. Perhaps, there is no bubble at
Currency intervention to save the dollar
The G-7 finance ministers met in Washington last week and
announced their �resolve� to minimize the volatility in the currency markets.
Many people took this to mean that foreign central banks would take a more
active role in shoring up the dollar. So far, there's been no indication of
support. The dollar has stayed within the $1.58-1.59 per euro range for
more than a week. Help could be on the way but, then, maybe not. The only
one who can really save the dollar now, is Bernanke. All he needs to do
is indicate that the rate cuts are over and the bleeding will stop.
Bernanke has already cut the Fed Funds rate from 5.25 per cent to 2.25 per cent
since September (way below the 4.1 per cent rate of inflation). It�s clear that
he sees a deflationary tidal wave about to hit sometime in the next
few quarters. Why else would he slash rates so aggressively?
Last week, former Fed chairman Paul Volcker took the unusual
step of publicly chastising Bernanke in a speech he gave to the Economic Club
of New York. Volcker's comments indicate the level of frustration with the
Fed's dollar-savaging rate cuts which have caused problems around the
world. Volcker said �The recession is not the Fed's problem. It's the
government's. The Fed's job is to defend the currency and fight inflation --
exactly the opposite of what this Fed is doing.� The former Fed chief thinks
Bernanke should raise rates now, because if he doesn't, he'll have to raise
them even more later, �with even more awful consequences.�
Martin Feldstein, chairman of the Council of Economic
Advisers under Ronald Reagan, joined Volcker in blasting the Fed and calling
for an end to the rate cuts.
In a Wall Street Journal editorial on April 15 Feldstein
said, �It's time for the Federal Reserve to stop reducing the federal funds
rate, because the likely benefit is small compared to the potential damage. . .
. Lower interest rates could raise the already high prices of energy and food,
which are already triggering riots in developing countries. In order to offset
the inflationary impact of higher imported commodity prices, central banks in
those countries may raise interest rates. Such contractionary policies would
reduce real incomes and exacerbate political instability. . . . lowering
interest rates stimulates economic activity to a point at which labor and
product markets cause wages and prices to rise. That is unlikely to happen in
the U.S. in the coming year. The general weakness of the economy will keep most
wages and prices from rising more rapidly. . . . .But high unemployment and low
capacity utilization would not prevent lower interest rates from driving up
�Lower interest rates induce investors to add commodities to
their portfolios. When rates are low, portfolio investors will bid up the
prices of oil and other commodities to levels at which the expected future
returns are in line with the lower rates.�
Additional cuts will probably have negligible effect on
housing and consumer spending, but they could be a fatal blow to the
dollar. It's not worth it. Lower rates will be devastating for people
living in poorer countries. In the US, middle class families spend only 15
percent of net earnings on food. In poorer countries people spend upwards of 75
percent of their income just trying to feed themselves. That's why riots are
breaking out everywhere; the Fed's monetary policy is a catalyst for political
Besides, lower interest rates don't necessarily increase
demand or make credit more easily available. The only way to spark demand
is to make sure that wages keep pace with production so that workers can buy
the things they produce. In other words, a prosperous economy
requires a strong and well-paid workforce.
Whitney lives in Washington state. He can be reached at firstname.lastname@example.org.
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