Has the Fed Painted Itself Into a Corner?
by ilene - October 17th, 2010 5:48 pm
Has the Fed Painted Itself Into a Corner?
Courtesy of Yves Smith
![[unclescrooge.jpg]](http://2.bp.blogspot.com/_azimCSzqNnc/SeGxAUpFFCI/AAAAAAAAA-Q/pthz4rvMbSI/s1600/unclescrooge.jpg)
A couple of articles in the Wall Street Journal, reporting on a conference at the Boston Fed, indicates that some people at the Fed may recognize that the central bank has boxed itself in more than a tad.
The first is on the question of whether the Fed is in a liquidity trap. A lot of people, based on the experience of Japan, argued that resolving and restructuring bad loans was a necessary to avoid a protracted economic malaise after a severe financial crisis. But the Fed has consistently clung to the myth that the financial meltdown of 2007-2008 was a liquidity, not a solvency crisis. So rather than throw its weight behind real financial reform and cleaning up bank balance sheets (which would require admitting the obvious, that its policies prior to the crisis were badly flawed), it instead has treated liquidity as the solution to any and every problem.
Some commentators were concerned when the Fed lowered policy rates below 2%, but there we so many other experiments implemented during the acute phases that this particular shift has been pretty much overlooked. But overly low rates leaves the Fed nowhere to go if demand continues to be slack, as it is now.
Note that the remarks by Chicago Fed president John Evans still hew to conventional forms: the Fed needs to create inflation expectations, and needs to be prepared to overshoot.
This seems to ignore some pretty basic considerations. First, the US is suffering from a great deal of unemployment and excess productive capacity. The idea that inflation fears are going to lead to a resumption of spending (ie anticipatory spending because the value of money will fall in the future) isn’t terribly convincing. Labor didn’t have much bargaining power before the crisis, and it has much less now. Some might content the Fed is already doing a more than adequate job of feeding commodities inflation (although record wheat prices are driven by largely by fundamentals).
From the Wall Street Journal, “Fed’s Evans: U.S. in ‘Bona Fide Liquidity Trap’”:
The Federal Reserve may have to let inflation overshoot levels consistent with price stability as part of a broader attempt to help stimulate the economy, a U.S. central bank official said Saturday.
“The U.S. economy is best described as being in a bona
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Relief rally as Eurozone liquidity issues fade; solvency and contagion still at issue
by ilene - May 10th, 2010 3:07 pm
Relief rally as Eurozone liquidity issues fade; solvency and contagion still at issue
Courtesy of Edward Harrison at Credit Writedowns
As in 2008, when global financial institutions were under attack, we are now facing a solvency crisis. This time the issue is Eurozone sovereign governments.
Make no bones about it, the EU’s trillion dollar gambit has worked and a melt-up is underway because near-term liquidity issues have been put to rest. But, this is not a liquidity crisis; it is a solvency crisis. And unless meaningful reform is taken in the Eurozone, this crisis will re-appear in due course.
Overnight, the Eurozone put together the European Stabilisation Mechanism programme, a hefty plan to provide fiscal support to any Eurozone government that runs into difficulty. While details are still coming into view, the euro and equity and bond markets have recovered tremendously. Meanwhile credit default swaps have fallen (see Marc Chandler’s pre-market summary here).
But, before we start popping the cork on the champagne, we need to realize that this stabilization mechanism and the developed market (DM) central bank swap lines only resolve liquidity issues. The genesis of this crisis is not liquidity, but solvency.
As I outlined in my last post on Germany (The Soft Depression in Germany and the Rise of Euro Populism), Germany has undergone extensive labour market reforms which Greece and Spain in particular have not. This makes Greek and Spanish labour forces uncompetitive vis-a-vis other countries also locked into the currency union, most notably Germany. The result, with the Euro well above its launch rate of 1.17 to the US Dollar, is international uncompetitiveness. Combined with extremely low interest rates, the result is a gaping current account deficit.
Unless the Eurozone attempts a beggar-thy-neighbour massive devaluation in the Euro, this closes off the export escape hatch for Greece and Spain. Therefore, in order to bring down enormous budget deficits and prevent national bankruptcy, the only option left is internal devaluation – across the board wage and spending cuts.
Ireland, which has faced similar pressures, is embarking on a path of internal devaluation right now to reduce their deficit. But reducing consumption demand at a point when the primary budget deficit is already double-digits still leaves the solvency question open. And Greeks have rioted to show the resistance to those kinds of measures.
My conclusion, therefore,…
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In Other News, Larry King is Selling Divorce Insurance
by ilene - February 8th, 2010 2:03 pm
In Other News, Larry King is Selling Divorce Insurance
Courtesy of Ken Houghton at Angry Bear
Many months ago, I quoted the brilliant Janet Tavakoli‘s book Credit Derivatives and Synthetic Structures:
The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea.
"That’s very interesting," I countered, "but the credit default option is worthless."
"But people are doing it," persisted the trader.
"That’s because they don’t know what they’re doing," I affirmed. "The correlation between Commercial Bank of Korea and itself is 100 percent. I would pay nothing for that credit protection. It is worthless for this purpose."
The trader mustered his best grammar, chilliest tone, and most authoritative voice: "There are those who would disagree with you." (p. 85)
Apparently, that anonymous trader—or another money-losing risk-mispricing hedge fund manager—is now running The Big C:
Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis. The firm has drawn up plans for a tradable liquidity index, known as the CLX, on which products could be structured that allow buyers to hedge a spike in funding costs….
"The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don’t worry about interest-rate exposures any more – they just pay a fee to hedge it," he says.
Because if funding dries up, The Big C will be there to support you!
I thought this was an attempt to make money on a premium, but it isn’t:
Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index’s movements around a fair strike value.
So the model is actually that you pay a higher cost of funds during good times, and during bad times, depend on the ability of your counterparty to make you whole.
When banks do it, it’s called "deposit insurance," and it is valuable because in the worst-case scenario, the U.S. Treasury can print money. Since—the last time I checked—Citigroup …
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Philip R. Davis is a founder Phil's Stock World, a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders...
Ilene is editor and affiliate program
coordinator for PSW. She manages the site