Monday, October 6, 2008

Raise the Fed Funds Rate: The Old World Order has Returned.

Right now sellers of credit won't sell to purchasers at the current price (interest rate). Were this any other market, economists would immediately say that, given the current supply and demand, the price is too low and prices (interest rates) should be allowed to go up. That was the recommendation for Soviet Russia grocery stores with their infamous lines. Increased prices reduce demand, increase supply and bring the market back into balance.

For over 70 years, however, the action of governments to credit crunches has been to increase the supply of credit by liquidity interventions. This was due to the fear of exacerbating the economic slowdown that inevitably accompanies a credit crunch. It has been so universal, and practiced so long (there is scarcely an economist alive who can remember any other way), that "increase liquidity" is a reflex response of all economists to a credit crunch. Economists have essentially forgotten that when supply is short and demand is set there are two possible actions; raise the price or increase the supply, and that normally economists recommend raising the price over increasing the supply directly.

Central banks, and the governments that back them, are mighty entities with great capacities. But like all human institutions, they have their limits. We have all become so used to the idea that governments can fill the credit supply shortfall created by low interest rates that we have forgotten they have limits and cannot supply infinite credit.

The current credit crunch has been caused by a truly massive worldwide destruction of financial capital. I have often read claims that the US housing bust, identified as the cause, isn't big enough to justify this. But there is much more than just a bust in US housing. There have also been massive real estate bubbles in many European economies, including England, Ireland, Spain, Poland, the Baltic states, and an old bubble in the Netherlands kept propped up for years. There is a major property bubble in China. There is a LBO bubble in most of the Western world, as well as extensive retail and hoteling bubbles. There is a large auto bubble in the US and large credit bubbles in the US and many other countries. Many have not yet gone bust, but the wise know at least most of them will, with vast additional losses.

I believe the losses simply exceed the ability of the current government to generate and reallocate capital. If so, no possible liquidity intervention will be able to hold credit prices to their current very low level (many real interest rates in the US are actually negative). Therefore, while governments should continue the current aggressive provision of liquidity, they should now raise interest rates until markets can once again clear given that additional (effectively subsidized) liquidity.

I say this is a return to the Old World Order because when currencies were meaningfully backed by gold and silver, governments were stringently limited in their ability to lower rates and create capital by the threat of specie flight. In those days, when a panic hit, interest rates had to go up. That Old World Order is now back; even with the considerable latitude provided by fiat currencies governments have hit their limits. Our credit is less than we might wish; we must choose which of our many competing targets will get it; and the most efficient way is by market allocation, which requires increased interest rates.

We can tolerate high real interest rates. Ask Paul Volcker. But we cannot tolerate failing credit markets. Our policymakers must accept their limits, encourge efficient allocation of limited capital, and restore public confidence by showing they understand this the realities of the credit markets.

(Hat tips to many people I've been discussing credit with, especially to evilhenrypaulson and AngrySaver. Anybody else who thinks they deserve a hat tip or link - tag me.)


Douglas said...


Just a question. Isn't the "big problem" the fact that banks are unwilling to lend to each other because they do not trust one another? Counter-party risk?

If so, what is needed is more transparency. Force everyone to disclose everything, and force everyone to mark everything to market.

Only in that environment, will it be possible to discern who is a good credit risk, and who is not.

You state "The current credit crunch has been caused by a truly massive worldwide destruction of financial capital."

Isn't that a symptom of the problem I describe but not the disease?



FairEconomist said...

Douglas -

I think transparency is part of the problem. But there are going to be *some* creditworthy banks and businesses no matter what the concerns, so I think there are problems clearing the market in addition to concerns with unknown risks. Besides, even if there are a lot of risky companies out, theory is that rates should jump to junk bond levels - not that lending should completely stop.

The vast credit destruction is the underlying cause of the fear. Many losses are not yet admitted and more not even yet knowable. It's those hidden losses which are giving everybody the willies. Without the losses most institutions would be solvent and transparency issues wouldn't be so critical.

P said...

I think your post is clear and useful. I have a question, however: is it possible that you are confusing cause and effect? Your argument is that we face problems BECAUSE governments for a long time have kept interests rates low. I certainly agree with this point. Governments have turned themselves inside out finding ways to keep rates of interest below the market clearing level. My suspicion, however, is that this effort by government is more symptom than cause. I offer three linked tendencies as root causes:
*falling marginal productivity of capital;
*ever increasing appropriation of resources by government;
*rising marginal cost of energy.
I won’t make a big argument for the validity of my thesis except to say that if we look at, say, the middle class since the 1960s, we see a group of people under pressure. First response to the pressure was women going out into the workforce. Second response was deeper levels of debt. Third response was out-sourcing.
To make the same point using slightly different language: it seems pretty clear that both wings of the Party of Government want a larger share of economy than can be produced in a system in which capital is correctly amortized (i.e., rewarded at a rate that allows it to be paid for AND replaced). In order to not impoverish the middle class – or create a revolutionary force – government has found ways to keep interests rates artificially low. What this means in practice is that 1) the built up capital from earlier generations is put into hock; and 2) not enough is produced in the system to replace what is used up by the system.
To fix these deeply rooted problems is not possible. There is no way that we are going to be able to go back to a world where --- for many generations -- the marginal cost of energy falls. Because no solution exists, government tries one expedient after another. Meanwhile those who are well positioned and smart (and who correctly sense that we are in a zero sum game) opt for a private solution, i.e., they grab as much as they can while the grabbing is good.

FairEconomist said...

P: good points on your comments. My opinions (have to think some on this):

Falling marginal capital productivity: This is a feedback loop with sub-market rates. Sub-market rates encourage inferior capital investment, reducing long-term growth, forcing the government to reduce rates further. IMO this has been going on cyclically since 1987, with every low-interest regime to "fix" the last bust causing another bubble of poor investment, producing a bigger bust.

Government expenditures: they were going down as a % of the economy during the '90s. Since the vast expenditures of the past eight years have been financed by deficits and done us very little good, yes, that amounts to wasted capital and exacerbates the problem.

rising energy costs: A real problem; but not really something the government can do much about. We've just used up most of the the cheap oil (and coal and gas, to a lesser extent) and that's the reality.

However, although I agree that the long-term policy of supplementing credit rather than raising rates has caused some problems, my specific argument above is focused on a different issue. The argument of to what extent the Fed should raise rates and to what extent it should subsidize liquidity during a crunch is something we don't have to, and couldn't, settle in the next few weeks. Whether you think it's good or not for the Fed to supplement/subsidize capital in crunches, the reality is they are currently doing all they can and we are going to be forced to take action on the demand side by raising rates. And that has to be faced immediately.

garyj said...

Absolutely spot on - the reason I was told that central banks set interest rates in a "free market" economy was to remove the volatility that private agents would cause at the anchor point of interest rate curve (overnight cash) In effect, the role of a central bank was as a smoothing agent, so that private individuals could make long term investment decisions without being uncertain about potentially high volatility in short end cash markets....and its knock on effects.

However, when central banks smoothing operations significantly disconnect for a prolonged period from where private agents would exchange overnight cash - we have a problem Houston!

Simple cause and effect - the volatility that they are then removing from the overnight cash markets is simply shifted to all other private markets in varying degrees depending on their immediate linkages to the "false" overnight market.

Central banks globally are thus massively off mandate - and as such are now causing the volatilty NOT reducing it.

How do we know they are off mandate - just look at things like the OIS spreads, etc, i.e. how far private markets are clearing from targetted official rates. The gap is only getting larger as the central banks "fiddle" or play "off mandate" - in my opinion.

Net effect at present is that the central banks need to significantly raise rates very close to estimate of private clearing levels (US$ rates 4-5%?? and get back on mandate.

Once they do this markets will start to settle down - probably some immediate spike in volatilty as markets digest the "proper" (not new)rules. Longer term this dampening of volatility is what will see rationl investors make rational investment decisions - as its the volatilty that central banks are trasmitting that is seeing rational investors stay on the sidelines.

Net effect - price discovery in nearly all markets is pathetic at best - therefore, markets are not clearing, therefore "for sale" assets continue to build, therefore buyer strike continues (they are looking at an ever increasing wave of for sale assets), therefore credit crunch goes on and on and on.....

Faireconomist - I have ready plenty of your comments on Yves sight and generally I feel we are coming from the same perspective.

Happy to take these discussions elsewhere.

Keep up the good work.

Gary Jeffery (

Andrew Foland said...

Hi FE,

I saw your note to Yves Smith, and I think it would be worthwhile for you to also post it here. It's nice work and would make it easier to find.


FairEconomist said...

garyj - interesting point about shifting uncertainty around. It would be interesting if there were some kind of "Heisenberg principle" which resulted in the central banks not being able to add any real information to the system, just shift it around. If so, there would still be the possibility that there is "irrelevant" information that the central banks could give up to generate the stability they want. This is what happen when you use a flashlight - you give up information about the light you don't care about to get information about the location of objects you do care about. But definitely something to look at.

There is also the "martingale betting" possibility, where you apparently eliminate the uncertainty of losing an even bet by doubling the bet every time you lose until you win. It seems this eliminates uncertainty, but actually it doesn't; it just concentrates the uncertainty to rare cases where your stake is completely wiped out. In a broad sense, that's what the current crisis looks like.

andrew foland - thanks for the suggestion. But I'm still trying to figure this thing out and if I post it "front pages" the post, which I don't want to do for now. Maybe I'll look for a widget to sidebar "pre-blog relevant posts".