The Dull Compulsion of the Economic (#7)

by Dollars and Sense

A series of blog entries by D&S collective member Larry Peterson.

It's been about a week since the Fed spoon-fed investors the elixir they'd probably priced into the markets for some time anyway, and the euphoria of the first two or three days is being replaced by more apprehension about the underlying calamities which the heroics of Bernanke and the others (poor Bank of England Governor Mervyn King got left out in the cold for this one) did almost nothing to address. On Monday, Deutsche Bank gave hints that it would take a very serious hit, indeed, and the dollar continued to fall against the Euro (the Canadian dollar even broke parity with it last week). So are investors beginning to factor in another rate cut for late October (of more than 25 basis points at that?)? If so, they do so without the sanction of bond traders: they are still spooked by inflation. Monday's Financial Times notes that (in the UK, anyway-where interest rates are even higher than in the US) "people in the credit world…have been eyeing the equity markets in recent weeks with disbelief." Are these fears reasonable?

Well, price pressure in the United States has moderated to a whimper after causing grave concern over the latter part of 2006 and into 2007. The Economist reported last week that consumer prices fell by .1% in August, which amounts to a 2% gain from a year earlier. Excluding food and energy, the so-called core rate of inflation rose 2.1% over the same period, which is the lowest rise in 17 months. And this with fuel prices pushing record highs, and the dollar tanking. So what are the bond traders scared of?

Well, as mentioned earlier, the central bank actions clearly are not adequate for much more than buying time. And time, accompanied by continued bad news, will become all the more expensive to finance. Banks are finding this to be the case in a particularly poignant way. The Economist also commented last week on the plight of banks who are being forced to swap loans maturing over three months for more expensive overnight ones every day in order to obtain the financing they need for a few reasons. The first is that they must come up with the extra reserves they need to cover the loans they have to put back on their balance sheets after unloading them on so called "conduits." These entities, which were basically front organizations, allowed banks to stow money away without having to put up reserves against them, thereby increasing the profits banks could make off them. But, given the fact that an unknown amount of these securities are tainted by the subprime crisis in particular and the securitization one in general, many banks are frantically putting up reserves now in anticipation of the possible extent of the blowback to cover both the funds they held reserves against, as well as those they'd stowed away, hoping for a little extra via "regulatory arbitrage." The fact that the banks need to put up more protection is causing short term rates to go up, and drying up the availability of funds on the interbank market in an impressive downward spiral. The Central Bank actions of the last few weeks have been designed to slow or reverse this process, by putting funds back into the interbank market (by changing the requirements for collateral—even subprime loans are being guaranteed by the Fed on the overnight market as collateral), and by simply easing the burden of the banks in meeting their day-to-day obligations (by setting key interest rates lower, banks both pay less for the money they borrow and avoid needing to stash away more in reserves, for lower rates attract fewer depositors). This, so the thinking goes, will allow them to keep lending, largely to each other, and so to kick start other nice money-spinners like leveraged buy-outs, which have all but dried up as of late. And, with that income, who knows? Maybe we could sneak through another crisis by constructing yet another bubble somewhere else.

So what of the long rates? Well, the economic growth outlook in the US has looked rather weak for some time now. This, no doubt, is what the bond market is focusing on. Usually, though, the kind of price weakness that accompanies a slowdown is favored by these folks, both as a "corrective" to the excesses that had resulted in the slowdown, and because bond prices rise with lower yields—and create value as long as inflation is tame. But with the dollar sliding, and the current account deficit still way, way out of reach (despite recent improvements), bond traders realize that the Fed has relatively little wiggle room to force it down (by keeping rates high), in such a time of turmoil. And that could lead to increased flight from the dollar, as investors recognize that the Fed is in a hopeless situation: if it attempts to raise rates to continue the massive flows of imported capital we will need far into the future, that can only raise inflation; but if it cuts rates too much, the US economy, which has been relying on cheap, debt-financed imports for all too long to keep domestic prices—especially that of labor—down, will no longer be able to afford the luxury of foreign competition to US production. And that means—guess what: higher inflation as domestic prices and interest rates go up. In a way, the bank saga, though instrumental in setting off the crisis, will take a back seat to this conundrum, no matter how—or if—it gets resolved. And, strangely enough, the Fed's conundrum looks a lot like the opposite of its comrades at the People's Bank of China: they fear raising interest rates there—which would, in turn, result in a favorable revaluation of the yuan versus the dollar—because, with every rise in rates, speculators would bet on yet even further rises, which would be all but guaranteed by the very speculative inflows the rate rises were designed to discourage. When the blind lead the blind, both fall into a ditch….

For some years now monetary policy in the rich countries (with Germany perhaps excepted) seems to have been carried on with a secret goal in mind: to allow for as much microeconomic restructuring—the costs of which are always borne disproportionately by the poor and working classes—as possible without serious macroeconomic instability (including large jumps in officially-measured unemployment, which, as we all know, lets all to many people fall through the cracks). Unfortunately, this has created the twin problems of rampant financial speculation as markets are deregulated, and debt-financing as incomes of the majority fail to keep up. So it looks like this game may be up. In a shocking display of bad taste at best, and ignorance at worst, a Lehman Brothers economist referred to last week's Fed action as "shock therapy." Most of the readers of this blog will need no reminding that the same phrase was used to describe the structural adjustment programs that caused "lost decades" for much of the poor and developing world. The only difference, of course, is that "shock therapy" for them meant jacking up interest rates to stratospheric levels—and subsequent capital outflows which enriched many Western investors, while for us, it has meant a dramatic drop in interest rates. But it may be that we in the West won't be able to be shielded by our great leaders from macroeconomic turbulence for too much longer. So we'd better come together and change the rules of the game before the game is up. 

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9/24/2007 10:58:00 PM