The Dam Breaks
The Fed's Open Market Committee, that supposed bulwark against monetary profligacy, has opened the floodgates with its latest move to push the federal funds rate to a forty-year low. It's the ninth cut this year, and the one that pushes the real rate of interest 1.3 percent below the median measure of CPI.
We are now waiting for just two of the eighteen Fed districts to join the party and cut rates. Already, the twelve domestic ones, the Bank of England, the Australian Reserve Bank, the Taiwanese, and the Hong Kong Monetary Authority have acted, leaving just the Koreans and the Bank of Canada to make it unanimous. Mainland China will no doubt follow shortly.
Again, we must ask: will it do any good? Certainly the Bundesbank must be entertaining doubts, as its president, Ernst Welteke, said that while it was not clear the U.S. was in a "liquidity trap" (I know, a Keynesian nonsense), it was questionable "whether rate cuts would work."
Easy money, contrary to orthodox belief, can do harm-not just in the Boom, but also in the Bust. Consider the following remarks from just the last few days' press:
Another lesson from U.S. experience (of the '80s) is the costs of poor incentives financial institutions face when confronted with struggling borrowers. A bank often does not want to force restructuring on a borrower, preferring to hide any losses by continuing to roll over loans. A bank's shareholders are not likely to demand action on problem loans, especially if the bank might become insolvent as a result. This set of poor incentives is especially true for a poorly capitalized bank. For these banks, a true resolution will result in a markdown of the value of the loan and a further decline in capitalization. To avoid regulatory scrutiny, poorly capitalized banks struggle to keep loans current, papering over the problem in the misplaced hope for a reversal of fortune. - Yomiuri Shimbun
But, naturally, not everyone has seen the light:
The crucial factor favouring companies struggling under a mountain of debt is that interest rates are so low. 'The great saving grace is low interest rates,"says a senior executive at a major British lender. "It is tremendously powerful. Carrying the cost of the debt is far lower than in previous downturns, which means that banks can afford to keep supporting a company for longer. Without such low interest rates, I believe we would have seen some spectacular corporate problems already." - UK Sunday Telegraph
Exactly. Banks are made flush with reserves just as they find that, in a time of business retrenchment, there is less natural demand for the credit they are now empowered to create. Those who do want money most often are not those with credible plans for expansion, but rather those struggling to survive the misallocations into which they have been deceived during the distortions of the Boom.
With falling revenues and over-geared balance sheets, the squeeze is obviously on. But if banks can lend these companies the money to service their own debts, rolling both interest and principal up into fresh credits at the new, artificially lowered short rates, the crunch may be postponed for a considerable time.
What makes this all the more seductive today, perhaps, is the lack of immediacy and the temptation to forego due diligence promoted by such third-party, "disintermediated" transactions as syndicated loans and, more emphatically, asset-backed securities (ABS).
Nearly $1 trillion of the former have been booked just since January, while ABS volumes are already 15 percent higher than at the same stage in 2000's record year. Even as credit quality deteriorates, banks are fighting for market share, securitizing ever more contingent payment schemes to pass to others, while "warehousing" more high risk on their own books, into the bargain.
ABS volumes have risen $1.25 trillion in the Bubble years from 1995 forward. Business-related borrowing in this form has risen 470 percent, or $460 billion, from 100 percent of the pre-tax profits of domestic non-financial companies to a heady 535 percent. Of more concern is that the most rapid growth-around 30 percent per annum, compounded-has occurred during the attempts to mask the fact that, in truth, the Asian Contagion of 1997 had put paid to the real upswing from the early '90s global slowdown.
Easy money has made all this possible. Good, you say; it avoids bankruptcies and layoffs and all those other unpleasant hangovers from the Boom.
If only it were that simple.
First, a misplaced faith in the Federal Reserve's supposed omnipotence, combined with the unabating but wholly ignorant propaganda that all will be well as long as everyone consumes, can lead individuals to maintain a lifestyle that is not compatible with their own best interests. Because only thrift can provide a foundation for growth, neither does faith in the Fed correspond with the interests of the industrial sector that consumers are supposedly saving by their valiant hedonism.
Private balance sheets, already led into dangerously high levels of debt, will thus not be repaired in due measure. They may be damaged even further, as yet more liabilities are contracted while waiting for the Fed's infamous six- to twelve-month "monetary lags" to expire and the economy and stock market to bound upward again.
More important, if easy money leads to malinvestment in the upswing, the ability to go into denial about that error in the downswing only prolongs that misallocation.
Keeping uneconomic entities operating for longer postpones recovery by crowding out (or dampening the resolve of) fresh, new, viable enterprises. It also works to undermine even the fittest in the old line of business who might otherwise have survived if they could have gained market share based on the superiority of their operating performance, rather than their access to a credit line. Airlines spring to mind here, among others.
Moreover, the longer this goes on, and the more poor loans banks make under the moral hazards and perverse incentives of the easy-money regime imposed by their supposed protectors at the central bank, the more likely it is that we impair, not just corporate, but financial capital, too.
In the inherently insolvent world of fractional reserve banking, that, in the extreme, risks panic or "systemic" failure. More probable is the less dramatic but equally debilitating slow deflation of ever-contracting credit multiples-a monetary version of freezing, rather than boiling, the metaphorical Frog in slow stages.
It would be the supreme irony if, in Greenspan's eager rush to bail out his constituents at the first whiff of every trouble from Y2k to WTC, from Latam to LTCM, and from Asian Contagion to Saxon Contraction, all he and his myrmidons on the lower slopes of Olympus have accomplished is to topple the very banks they are there to protect.
In this, they are replicating the errors of the old-style Bank of Japan and its charges among the giants of Japan's own Jurassic heyday.