Pushing on a String? Or on an Elastic Band?
Depends on the future of the dollar. From an indispensable post by Yves Smith:
Monday, November 24, 2008
Government Lending Support Pledges and Measures At $7.4 Trillion
Second, this effort cannot achieve its stated aim. We have said before that the markets are too large for government to salvage. Paul Krugman also made this point in March:
….the financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it’s usually because of the “slap in the face” effect: the markets are getting hysterical, and intervention gives them a chance to come to their senses.
And the problem now becomes obvious. This is now the third time Ben & co. have tried slapping the market in the face–and panic keeps coming back. So maybe the markets aren’t hysterical–maybe they’re just facing reality. And in that case the markets don’t need a slap in the face, they need more fundamental treatment–and maybe triage.
The Fed inceasingly has been trying to stand in for private lenders, but it cannot take on the entire private sector. And let’s look at orders of magnitude.
US debt to GDP stood at 350%. as of March 31, 2008. There are some items that are arguably overstated (lines of credit are included at their full amount, but second and third mortgages not included, and perhaps most important, contingent exposures like AIG’s credit default swap guarantees). It isn’t unreasonable to assume they net out.
The Fed’s proposed intervention is a bit more than half of GDP. However, note it (and the Treasury) has already made, and will continue to make, considerable commitments to non-US parties. AIG., for instance, has over $300 billion in CDS exposures in guarantees that permit European banks to evade minimum capital requirements (and AIG also has other, substantial non-US exposures). Similarly, the most likely cause of a Citi meltdown would be withdrawals of uninsured deposits, which were primarily overseas. Moreover, the Fed has also provided considerable indirect support to non-US entities via providing unlimited dollar swap lines to other central banks.
That is a long winded way of saying that not all of that $7.4 trillion applies to exposures that fall in the 350% debt to GDP figure cited above. Just to pick a number, say $6 trillion of the total goes to US debt. The US debt was $49 trillion. The Fed can commit less than 1/8 of the outstanding debt to solve the problem. Per Krugman, do we really think this will work? And if it does not work, it will make matters worse by increasing the size of the debt overhang when it needs to contract.
Third, as Wolfgang Munchau said today in the Financial Times and others have pointed out earlier, the Fed seems worried solely about deflation, and not about a possible US currency crisis. This is a shocking oversight. The Fed (and many others) keep drawing analogies between the US in the Great Depression and its situation now. That is flawed and dangerous.
The US was a massive creditor before the Depression and ran a very large trade surplus, to the point where the gold accumulation by the US was destabilzing to the world financial system. Sound familiar? That is the role China plays now, not the US.
What happened to the nations that were in the US’s shoes at the onset of the Great Depression, the overconsuming, indebted European customers of the US? They devalued their currencies, defaulted (or partially defaulted and forced a renegotiation) on foreign debts, and suffered milder downturns than the US did.
But the authorities are not even considering the possibility of debt default or a dollar crisis in their plans. And if you think recent dollar strength argues against it, think again. The massive dollar purchase are due to unwinding of dollar based debt. Similarly, the massive rally in long-dated Treasuries was due to massive short covering on shorts written many years ago in connection with funky products to lower the cost of the product. A Treasury short that was then so far from recent yields was seen as free money. It turned out not to be).