Today In Economic Armageddon

The Federal Reserve joined forces with central banks across the world for a coordinated interest rate cut of 50 basis points. They're obviously throwing concerns about inflation out the window and trying to kickstart the credit markets, but Paul Krugman explains why that is not likely to work.

A quick illustration: in early July 2007, before the crisis, the target Fed funds rate was 5.25% and the rate on 30-day A2/P2 commercial paper — that is, CP issued by less-than-sterling borrowers — was 5.4%. On Monday of this week, the target Fed funds rate was 2%, down 325 basis points from pre-crisis levels, but the CP rate was 5.61% — up from pre-crisis levels.

So will this latest rate cut make any difference to borrowers? Maybe — but only to a few of them. We’re way past the point at which conventional monetary policy has much traction.

On top of this you have the Fed jumping into the commercial paper market, perhaps illegally, to get the rates they can't touch through monetary policy lowered. And they're starting to lend to private companies, putting more taxpayer dollars at risk.

These look like desperate attempts to stave off the inevitable, and nobody's really certain whether or not they'll work. What I think we have here is the policymakers in the White House trying to rescue their failed ideology and not the market. They want to use everything in their power (and a few things that aren't) to halt a slide to recession, as long as it doesn't look socialist and icky. What's more, they'd rather reward their friends on Wall Street than punish them, even though they have the opportunity to do either with the authority granted in the Paulson plan. The wiser move would be to follow Britain and just nationalize the banks already.

Britain’s largest banks are to be part-nationalised after the government took the momentous decision to pump tens of billions of pounds of public money into the sector to avert a banking collapse [...]

Under the UK bank rescue, the government is to put up to £250bn into the banking system in an effort to keep banks lending. It will also offer a guarantee to banks issuing medium term debt, which could mean backing a further £250bn of bank borrowings. But it is likely to demand dividend cuts and the end of big bonuses at the banks in return.

This is clearly what we should be doing here; a Swedish-style temporary nationalization with large equity stakes. It's cheaper and is more likely to be effective. And it looks like Emperor Paulson is slowly resigning himself to that reality:

Did anybody else notice that when Hank Paulson was describing in his press conference today what the Emergency Economic Stabilization Act enables Treasury to do, the first thing he listed was “to inject capital into financial institutions”?

That wasn’t how Treasury initially advertised its Troubled Asset Relief Program. It was sold as a way to get the market for mortgage securities moving (or, to use the jargon, liquid). Lots of academic economists objected that liquidity wasn’t the problem, it was insolvency. What Treasury needed to do was recapitalize financial institutions and take equity stakes in return […]

None of the people asking questions at the press conference really seemed to pick up on this, of course (&%%$# Washington journalists!). Along with Paulson’s affirmation that the FDIC was going to use its “systemic risk” powers to protect depositors and unsecured creditors “as appropriate,” I take it as one more sign that we’re headed toward a Swedish solution of our banking crisis—recapitalization and temporary nationalization of much of the banking system.

The second half of this needs to be a real stimulus bill for ordinary Americans which includes aid to state and local governments as well as infrastructure investment. And that's exactly what Nancy Pelosi is calling for.

DENVER - House Speaker Nancy Pelosi said Wednesday that a $150 billion economic stimulus plan is needed now because of the faltering economy and she may call the House into session after the election to pass it [...]

The Senate is expected to be back at work after Election Day to complete a public lands bill and perhaps deal with other matters, such as a measure to extend unemployment benefits. The House also could return to consider a stimulus plan and additional issues in a lame-duck session before the newly elected Congress takes over in January.

"We may have to go back into session before the next Congress," Pelosi said.

Pelosi said a stimulus package would create jobs by investing in public works, increasing food stamps benefits and extending unemployment insurance for the long-term jobless. She said lawmakers need to "hunker down" and look closely at the federal budget for possible savings, and reconsider whether the U.S. can afford to fight "a war without end" in Iraq.

Reality is intruding on the fantasy scenario that we can continue to prop up the financial system with funny money. The reckoning is going to be painful but we should at least start to head in the right direction.

Borrowing Money Costs Money

The more that this financial system unwinds, the more that I am amazed it lasted this long. It reminds me of the Monty Python sketch where the Amazing Mystico conjures up a block of flats.

Voice Over: But even more modern building techniques are being used on an expanding new town site near Peterborough; here the Amazing Mystico and Janet can put up a block of flats by hypnosis in under a minute.

Mystico removes his cloak, gloves and top hat and hands them to Janet, who curtsies. He then makes several passes. Cut to stock film of flats falling down reversed so that they leap up. Cut back to Mystico and Janet. She hands him back his things as they make their way to their car, a little Austin 30.

Voice Over: The local Council here have over fifty hypnosis-induced twenty-five story blocks, put up by El Mystico and Janet. I asked Mr Ken Verybigliar the advantages of hypnosis compared to other building methods.

Cut to a man in a drab suit.

SUPERIMPOSED CAPTION: 'MR K. V. B. LIAR'

Mr Verybigliar: Well there is a considerable financial advantage in using the services of El Mystico. A block, like Mystico Point here, (indicating a high-rise block behind him) would normally cost in the region of one-and-a-half million pounds. This was put up for five pounds and thirty bob for Janet.

Voice Over: But the obvious question is are they safe?

Cut to an architect's office. The architect at his desk. Behind him on the wall are framed photos of various collapsed buildings. He is a well-dressed authoritative person.

SUPERIMPOSED CAPTION: 'MR CLEMENT ONAN, ARCHITECT TO THE COUNCIL'

Architect: Of course they're safe. There's absolutely no doubt about that. They are as strong, solid and as safe as any other building method in this country provided of course people believe in them.

Cut to a council flat. On the wall there is a picture of Mystico.

Tenant: Yes, we received a note from the Council saying that if we ceased to believe in this building it would fall down.

Voice Over: You don't mind living in a figment of another man's imagination?

Tenant: No, it's much better than where we used to live.

Voice Over: Where did you used to live?

Tenant: We had an eighteen-roomed villa overlooking Nice.

Voice Over: Really, that sounds much better.

Tenant: Oh yes - yes you're right.

Cut to stock shot of block falling down in slow motion. Cut back to tenant and wife inside. Camera shaking and on the tilt.

Today we learn that the Federal Reserve is going to buy commercial paper, which is the short-term debt that banks lend to one another. Kevin Drum explains how this works, and how the financial system is crumbling because, well, people stopped believing in it:

COMMERCIAL PAPER....Banks, finance companies, and large corporations routinely finance their ongoing operations by issuing short-term debt known as commercial paper. It's denominated in large amounts (typically a million dollars or more), it's unsecured, it's low cost, it matures quickly (typically in 30 days or so), and it can be issued easily because it doesn't have to be registered with the SEC. Without access to commercial paper, large modern corporations would seize up and die.

Which, unfortunately, is what's happening right now. The commercial paper market is essentially frozen, and as notes mature and need to be rolled over, companies are finding it impossible to get routine financing. (This is how "Wall Street problems" turn into "Main Street problems.")

This is just a back-door way to nationalizing the banks, but in the worst way possible. The commercial paper market is bigger than the $700 billion dollars given to Treasury in the bailout, and if it's seized up, in the short term the Fed will be buying a healthy percentage of it. This crisis of confidence is what the bailout was designed to fix. And they're doing it without consulting Congress.

Anyone else notice that the Fed just keeps doing these things without bothering for things like Congressional approval? Things that it doesn't actually have the legal right to do? (The Fed isn't supposed to lend money if there's a possibility of losing money) Paulson may have tried a huge money and power grab, but he at least went to Congress for it.

Is it a good idea? Not really. But it's a less stupid idea than the bailout. Most of the paper will pay back, there isn't a huge amount of risk in it (though some is backed by mortgages and other assets, or by companies which are shaky, so there isn't no risk) and it is short term. It's probably necessary at this point, since TARP will do nothing to solve any of the fundamental financial or economic problems and people know it. A plan that had, oh, put a floor under housing prices say, or which had given the FDIC authority to take over banks that aren't lending (if you aren't lending you must be insolvent, right?) might have worked. Paulson's "bailout" - (buy) up a small percentage of trillions of dollars of trash on companies books - won't.

The essence of this is that banks want to be able to swap money for debt without paying any cost in the exchange. They want to secure cheap credit so they can hand out cheap credit. But universally cheap credit is why we're here in the first place. And now, with all these outlays and the Fed continuing to print money, somehwere down the road it's going to lead to massive inflation (although oil is going down now as the overall economy slows).

But endless borrowing costs money. And when you lose a bunch of money the way all these players did in the housing market, there's nothing left to borrow. And then everyone stops believing in the system.

Maybe that's because it wasn't that good a system to begin with, one that needs to be reformed.