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Will Paulson’s plan save the US economy?
Dr Frank Shostak
Given last week’s dramatic events — the bankruptcy of Lehman Brothers, Merrill Lynch lost its independence and a $85 billion US government bailout of insurer AIG — most financial institutions are likely to become more sensitive to the state of their net worth.
For instance, all it takes for a financial institution that has a net worth of $30 billion and assets of $600 billion to go under is for the value of assets to fall by 5 per cent. In the current financial climate it can easily happen, hence most financial institutions are not immune from the potential threat of going belly up.
One of the major reasons why the Fed rescued AIG was to prevent a fall in the value of bank assets, which in turn would expose their true net worth. This, it is generally believed, could cause a run on banks and decimate the entire banking system. As long as the AIG pay-outs for the loss of value of various insured suspect investments that banks made remain intact banks don’t need to reappraise their true values. But there is always the lingering fear that at some stage banks would be forced to disclose market related valuations and this could set in motion a financial tsunami, so it is held by most experts.
Mortgage-linked assets are regarded as at the root of the present worst credit crisis since the Great Depression. To eliminate a potential threat from devalued mortgage — linked assets US Treasury Secretary Paulson and the Fed chairman Bernanke are planning to move them from the balance sheets of financial companies into a new institution. Congressional leaders who met with Paulson and Bernanke late last Thursday in Washington said they aim to pass legislation soon in this regard.
But how is the transfer of bad paper assets to some new institution and replacing them with a better quality assets, let us say with Treasuries, going to fix the economy? How can it reverse the present slump in the housing market? By allowing financial institutions to get rid from bad assets the Treasury and the Fed believe that this will remove the threat of forcing banks to assign correct values to their suspect assets. It is held this will bring things back to normal — the banks will start expanding mortgage loans and revive the housing market and in turn the economy. We suggest that by allowing banks to get rid of bad assets doesn’t imply that they will be keen to start accumulating potentially bad assets again by expanding mortgage lending.
At present for most US banks the major concern is improving their net worth i.e. strengthening their solvency. This means that banks are likely to slow the pace of expansion of their assets i.e. the volume of lending is likely to come under pressure. In the week ending September 10 commercial bank total assets fell by $33.9 billion. The yearly rate of growth of total assets fell to 4.9 per cent from 6.7 per cent in August and 12.7 per cent in March. According to the Federal Deposit Insurance Corporation (FDIC) commercial banks and savings institutions net worth fell by $10 billion in Q2 from the previous quarter. This was the first decline since the data was made available — Q2 2000.
At the root of the problem is not mortgage-backed assets as such but the Fed’s boom-bust policies. It is the extremely loose monetary policy between January 2001 to June 2004 that set in motion the massive housing bubble (the fed funds rate target was lowered from 6 per cent to 1 per cent). It is the tighter stance between June 2004 to September 2007 that burst the housing bubble (the fed funds rate target was lifted from 1 per cent to 5.25 per cent).
The tighter monetary stance put a brake on the diversion of real savings towards bubble activities. Now the effect of a change in monetary policy operates with a time lag. We suggest that the tighter interest stance of the Fed between June 2004 to September 2007 has so far only hit the real estate market and financial institutions.
Various bubble activities that sprang up on the back of loose monetary policy between January 2001 to June 2004 are not only in the real estate and financial sectors, they are also in the other parts of the economy. Consequently, there is a growing likelihood that these activities will come under pressure. Since they are the product of loose monetary policy obviously the banks that supported them are going to incur more bad assets, which will put more pressure on banks net worth.
The US Congress may help Bernanke to increase monetary pumping
The rescue package is a combined act by the US Treasury and the Fed and is seen by experts as a comprehensive approach since it also addresses the issue of liquidity. The Chairman of the Fed, who is fearful that American economy could plunge into depression, holds that the only way to prevent this is through massive monetary pumping.
We suspect that Bernanke is of the view that so far he wasn’t allowed to operate “properly” and prevent the current upheavals in financial markets because he couldn’t pump money at liberty. In the present set-up of the interest targeting the Fed cannot simply pump money unhindered into the economy and boost monetary liquidity. Monetary pumping, whilst the fed funds rate is at the target, will push the rate below the target. To bring the fed funds rate back to the target the Fed is obliged to sell assets like Treasuries to absorb money from the fed funds market.
All this means that if there is no upward pressure on the fed funds rate the Fed cannot pump money without pushing the rate below the target. For instance, if the Fed increases lending to a financial institution the new money, which will enter the financial market, will put downward pressure on the federal funds rate.
To eliminate this downward pressure the Fed will be obliged to sell Treasury securities. By selling these securities the Fed takes money from the market. In this way the US central bank offsets the downward pressure on the federal funds rate brought about by the increase in lending to financial institutions. Note that the holdings of Treasuries by the Fed play an important role in the process that we have described.
As a result of all the actions to boost liquidity taken by the Fed since August 10 2007 the US central bank holdings of US Treasury securities has dwindled. Just a year ago the Fed held $780 billion in Treasuries by September 17 2008 this has fallen to $480 billion. Year-on-year Treasury securities holdings by the Fed fell by 38.8 per cent in August after falling by 39.4 per cent in the month before. This was the 10th consecutive month of yearly decline.
So far in September the yearly rate of growth stood at negative 38.5 per cent. If we allow for $200 billion that the Fed pledged to the Term Securities Lending Facility and the $85 billion loan to AIG then the amount falls to $195 billion. If more institutions were to be on the brink of bankruptcy and the Fed were to decide to provide support to them it would have difficulty in doing so without a sufficient inventory of Treasuries. Again if the Fed were to run out of Treasuries then any lending by the Fed would lead to the federal funds rate to fall to below the target.
To help Fed out last Wednesday the US Treasury announced that it would auction $100 billion in debt in order to offset the monetary pumping by the Fed. Observe again that officially the Fed has been engaged in actions to boost liquidity since August 10 2007. All this means that the Fed might appear to be loose but in reality the overall pumping by the Fed as depicted by its balance sheet so far has been moderate.
The yearly rate of growth of Fed’s assets stood at 4 per cent in August against 3.8 per cent in July. Note that since November 2004 the growth momentum of Fed’s assets has been in a downtrend (the yearly rate of growth in November 2004 stood at 7.1 per cent).
How can the Fed boost the money supply?
So how can the Fed boost the money supply without pushing the fed funds rate to below the target? One way of achieving this is by asking the Treasury to issue more debt. Once the Treasury sells more debt to the public this absorbs money from the federal funds market. As a result the fed funds rate will be pushed above the target. Once this happens the Fed will step in by buying the Treasuries from the public.
Remember that by buying Treasuries the Fed injects money to the federal funds market. The new money in turn pushes the federal funds rate back towards the target. The final outcome of all this is that the money supply has increased and the Fed now has more Treasuries i.e. its balance sheet has increased. Now this way of boosting money supply and monetary liquidity is somewhat cumbersome. It also raises the level of the Treasury debt and pushes long-term yields and hence mortgage interest rates higher than it would have been.
The better way according to Bernanke and US central bank officials is to pump money any time they think it is necessary. Not only this will boost monetary liquidity but it will also boost the Treasuries holdings by the Fed. (Remember to pump money the Fed buys Treasuries). But how can this be done given the fact that to keep the fed funds rate at the target prevents the Fed from pumping money at liberty?
A solution is on its way here — to pay interest on bank deposits held at the Fed. By paying banks an interest rate, which corresponds to the target rate, the Fed removes from banks the incentive to lend surplus cash to each other. As a result the fed funds rate will not fall below the target in response to Fed’s monetary pumping.
(Remember when more money is pumped banks surplus cash increases. To get rid of the greater surplus they will agree to lend at a lower interest rate than before).
When every bank is guaranteed interest on its deposit with the Fed banks will not lend to each other — why bother to lend and incur risk if a bank will be paid interest by just keeping the money at the Fed. Consequently, the interest rate will not go down on account of the increase in the Fed’s pumping. With this set-up the Fed could pump money at liberty without pushing the fed funds rate to below the target.
We suspect that against the background of last weeks events and the emerging view that something drastic must be done to prevent a calamity there is a high likelihood that the Congress is going to approve the Fed’s i.e., Bernanke’s, request for paying interest to banks very soon. Once the Congress will give the green light we envisage that Bernanke will start pushing a massive amount of money to soften the crisis in the credit markets.
The idea here that this should boost bank lending, which in turn will kick-start the economy. Some experts are arguing that the Fed needs to pump over one trillion dollars to make things work.
Can more money pumping fix the current economic crisis?
But why should pumping more money do the trick? It seems that for most experts money is an agent for economic growth. Money however is just a medium of exchange and it cannot create real wealth as such. On the contrary monetary expansion results in the squandering of real wealth and economic impoverishment. (A good example that this is so is Zimbabwe). If the pool of real savings is declining then real economic growth will follow suit regardless of how much money the Fed is going to pump.
Declining household net worth raises the likelihood that the pool of real savings could be in trouble. According to the Federal Reserve flow of funds data the net wealth of households fell 0.8 per cent in Q2 as both home values and financial assets values fell. This was the 3rd consecutive quarterly decline. In its press release the Fed said it has never before recorded three consecutive quarters of declining household wealth since it began tracking quarterly changes in 1951. Year-on-year net wealth fell by 3.5 per cent in Q2 after falling by 0.7 per cent in Q1.
Conclusions
What the government and the Fed are trying to do is to preserve various non-wealth generating structures. By preserving such structures the authorities only weaken further the already shaky pool of real savings — the heart of the economy. Remember that as long as a non-profitable structure is allowed to stay alive it undermines and thus weakens wealth-generating activities.
(A non-profitable entity, which is allowed to stay alive, diverts real savings from wealth generating activities).
Since neither the government nor the Fed can create real savings it means that their various policies of fixing things will severely impoverish the private sector of the economy. Obviously if the pool of real savings is still expanding then the economy will recover on its own accord. If however the pool is declining then by damaging the pool of real savings further by means of a so called rescue plan the authorities are going to delay the prospects for a meaningful economic recovery.
Dr Frank Shostak is a former professor of economics who now works in the private sector
BrookesNews.Com
Monday 29 September 2008