The Short-Term Problem

Stirling Newberry:

Right now there is a simple problem. There are three market participants in the short term credit market. The Fed, the equities buyers, the banks. These are relatively much, in order, the government's preferred demand target, the demand for money, and the demand for interest. Right now they have radically different ideas of what the prices are. The Fed has interest rates at 1.5%, though this is an emergency cut from the 2% they had before. The equities market thinks that interest should be about .5%. That's why the hot money from the equities market has flooded treasuries, and what the cost of short term money is. The banks think that overnight rates should be somewhere between 3% and 6%.

That's why the credit markets are seizing up, there is no way to get the market to clear if the people who want money see the basic risk premium as low and it is time for a steep yield curve and expansion, the people who are the proxy for controlling demand think it is time for a shallow yield curve and moderation between growth and inflation, and the people charging for money think that the inflation and risk premiums are high. One doesn't need to invoke non-existent "counter-party risk." In fact, the LIBOR curve says the reverse: if it were counterparty risk, then long term libor rates would be much higher. But they aren't. If it is risky to loan today, then why is it less risky to loan for a year? It isn't. Banks aren't lending because rates are not attractive.

So who is right? Well, all of them, and that is the short term problem.
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The simple spread between the Fed rate, and inflation expectations, alone, would be enough to create a problem. But this problem has created a second problem: namely that banks now must charge for new CDS [Credit Default Swap -ob] rates. The "toxic waste" isn't clogging balance sheets as much as the inability to get default insurance at reasonable rates, is making it unwise to lend, especially in the context of deflationary expectations.

That is, why make a risky loan today, when you can buy the asset itself tomorrow at book value?

This means that what is driving the banks is liquidity preference, but not out of fear of the unknown, but fear of the known.
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Now if the Congress were an effective body, one that was capable of working on policy, and Ben weren't "Captain Carnage" there are solutions. However, Congress is eager to bribe constituents. It wants to send out more checks to people. Joy. More inflationary idiocy. Not that the executive has garnered a great deal of trust, but this Congress has proven itself to be innumerate, incompetent, and invertebrate.

What then must happen is a combination of fiscal and monetary policy which is designed to prop up those hit with the lack of liquidity and rising risks, and at the same time a club to beat down those risks. Congress, rather than talking about giving people more money to do the wrong things, should be finding ways of dramatically slashing consumption. Not for general austerity's sake - contraction and liquidation are not the point - but to free up resources for the deeper project.
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Thus, this crisis will not be pretty, but the powers that be have learned nothing from it. Their response will be to overheat the old economy. Drill! Dig! Burn! will be the order of the day. Build coal plants! Drill for Gas! Drill! Drill! Note that they say drill, and not extract. Drilling holes in the ground, by itself, is not a meritorious activity. There needs to be something down there to drill for.

Short term it is time to be buying equities, because there will be a hard bounce when this new and improved ponzi scheme - and now that is where we are, in the land of paper money ponzi schemes, were new people coming into the economy will be paying for people who want to bail out - gets put on line. However, it is no more destined to last than the rally after the Iraq War. A rally that is now fully discounted as having been invested in all the wrong places.
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But that's their view: fix the paper, and then go back to borrow and squander. Far from critiquing the "failed policies" of Bush, so far, they are promsing merely a repetition of them, run by different people. That may help in the short term, because Bush's ability to execute on even his own plans is feeble. The only thing he's ever been good at is stealing elections, or engaging in a leveraged buy out of them. However, the basic premise, that we can go back to land flipping and burger flipping internally, while making our money by blowing up Baghdad one block at a time, is fundamentally flawed.

This means, absent a sudden and completely unexpected attack of sanity, in a few years, we will be back here, only worse.

The American people have decided to ride this bucket all the way down. There will be a bounce off this ledge, but not one that people should have any faith in, because the leadership, like the public, is in a simplistic mode of demanding that we go back to doing all the wrong things, and solemnly pass laws that someone else will pay for it.
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The bail out bill was billed as a way to protect the market. Obama intoned that those of us who were against it wanted the market to fall. The markets have been in free fall ever since Obama got his bail out bill, in the form he wanted it with TAX CUTS TAX CUTS TAX CUTS. Clearly his judgment on the economy needs some more development. What the Pillsbury Doughboy and his all moose orchestra think about the economy is beside the point. McCain is on every side of every issue, except that we know he is against doing anything which does anything, and his running mate is against ever allowing a black person to have any money, ever, under any circumstances. Politics is often the choice between the unpalatable and the disastrous, but right now, we don't even have the unpalatable on the ballot. Just the disastrous and the catastrophic.