Tuesday, January 13, 2009

Foot-in-Mouth Outbreak update I

From today’s WSJ – hat tip to Paul – see the first comment here:

“So the Fed is again in the position of "pushing on a string" and finding that nothing happens. Some economists describe this as a "liquidity trap." Money creation loses its stimulative power -- vastly overrated even in ordinary times -- because public demand for loans is weak. Americans are too strapped financially, too short on investment opportunities, or too concerned about the future to borrow. They prefer to save instead.”

This makes sense, especially in Ireland – the incessant blabber we are now accustomed of hearing from the Dail – the Government and the Opposition – is that the banks must start lending to the households and the corporates. But, as I pointed out on numerous occasions since last summer (including in the posts here), there is no demand for these loans – Irish households (the most indebted in the EU) and companies (the most indebted in the EU) simply have no demand for new loans. Hence, the main problem faced by the Irish government is de-leveraging of companies and households, not recapitalizing the banks!

According to WSJ:
“Some economists argue that... the new money the Fed has pumped into the economy to replace the financial-sector liquidity wiped out by the collapse of the bubble has to go somewhere, they point out. It has to end up in someone's bank account and banks have to quickly convert deposits (liabilities) into investments or go broke even faster than some have by loading up on polluted, mortgage-backed securities. Maybe "liquidity malfunction" is a better term than "trap."”

The malfunction, according to the WSJ is that the money creation feeds US Government spending, yielding little benefit for the private sector. It is, according to the WSJ article – a Keynesian policy Redux, not a monetary policy paradigm.

I agree with that view. In September this year I authored a research note – which was never published – saying that the US Fed’s monetary operations – ‘helicopter drop of money’ and monetary policy easing can be viewed as a Ponzi game. Ditto for Ireland’s banks guarantee scheme and banks rescue package. I returned, briefly, to this is my Business&Finance column in November 2008.

Effectively, the rescue policies work like an old fire engine pump – the flow of funds from the Treasury to the Fed to the Treasury passing through the markets creates a vacuum of liquidity in the associated securities markets. Think buying bonds, liquifying existent positions at a discount, and then selling new bonds at a premium, thus generating net negative position. These flows sap private and foreign liquidity out of the private sector loans market and into public sector stimulus financing (or assets purchasing, banks propping and Detroit rescues). In effect, this ‘liquidity’ pump is destroying any hope of private credit markets return to some sort of stability, while financing Treasury's operations.

The thing is that, while we do need to prop up some financial institutions, if you push liquidity flows through household balances – by forcing the banks to issue new equity/options and write down loans – you use the liquidity to achieve both – provide a pool of potential loans and deleverage households. Only then will you simultaneously solve the twin problem of:
(1) shortage of loans supply;
(2) shortgae of loans demand.
Not a single politician to date cared to listen.

Yet, this is exactly what the article in the WSJ is saying...
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