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Wednesday, September 17, 2008

In The Beginning, There Was The Word

Update: It's 3:00 AM. The phone rings at the Fed....

Today, the Bank of Canada, the Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank are announcing coordinated measures designed to address the continued elevated pressures in U.S. dollar short-term funding markets. These measures, together with other actions taken in the last few days by individual central banks, are designed to improve the liquidity conditions in global financial markets. The central banks continue to work together closely and will take appropriate steps to address the ongoing pressures.

Federal Reserve Actions
The Federal Open Market Committee has authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide dollar funding for both term and overnight liquidity operations by the other central banks.

The FOMC has authorized increases in the existing swap lines with the ECB and the Swiss National Bank. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $110 billion by the ECB, an increase of $55 billion, and up to $27 billion by the Swiss National Bank, an increase of $15 billion.

In addition, new swap facilities have been authorized with the Bank of Japan, the Bank of England, and the Bank of Canada. These facilities will support the provision of U.S. dollar liquidity in amounts of up to $60 billion by the Bank of Japan, $40 billion by the Bank of England, and $10 billion by the Bank of Canada.

All of these reciprocal currency arrangements have been authorized through January 30, 2009.

Information on Related Actions Being Taken by Other Central Banks
Information on the actions that will be taken by other central banks is available at the following websites:

Bank of Canada Leaving the Board
Bank of England Leaving the Board
European Central Bank Leaving the Board
Bank of Japan Leaving the Board
Swiss National Bank Leaving the Board

End update.

I'm reprinting this entire Bloomberg article because this is a piece of history, the rhyming kind. I'm not sure if the average non-financial person would quite grasp the nature of what is being said here. If you don't, I strongly recommend reading Quincy Howe's World Diary 1929 - 1934, which is available online for free, and practically unobtainable otherwise, because I am not surrendering my copy. Previous post about this book (you may have already read it).

The proposal is basically for central banks to bail out everyone, including foreign banks, with the focus on the Fed doing the bailing, since "a shortage of dollars is among the most pressing problems". If you are not familiar with the run-up to the Great Depression, back then the problem was the shortage of gold, and the US tried to bail and failed miserably. There is a great deal of detail about the part the French played back then in the online book, and I suggest you read it. Having your head up your butt may be a cultural feature.

On to the Bloomberg article.
Sept. 17 (Bloomberg) -- Central bankers may need to take a more global approach to steadying financial markets with actions that include making it easier for banks to borrow across borders.

Credit remained scarce today even after central banks added more than $200 billion in extra funds this week. Banks hoarded money, concerned that more financial institutions will follow Lehman Brothers Holdings Inc. into bankruptcy. The cost of borrowing in dollars for three months jumped the most since 1999 with the crisis spreading abroad as U.K. mortgage lender HBOS Plc slumped and Russia poured money into its banks.

The remedy may be what Bank of Italy Governor Mario Draghi yesterday called a more ``internationally coordinated effort.'' To ease market tensions and stop them from plunging the world into recession, central banks may need to accept additional collateral denominated in foreign currencies and lend more to banks abroad. The Federal Reserve might also need to dispatch dollars around the world more quickly.

``The central banks may get more bang for their buck by working together more instead of the patchwork approach,'' said David Hensley, an economist at JPMorgan Chase & Co. ``If they did something in a more unified way, it would carry more weight in markets.''

So far this week central banks have worked unilaterally to address liquidity shortages. Russian policy makers today cut the reserve requirements for banks as the country faced its worst financial crisis since the government defaulted on domestic debt a decade ago.

Special Program

The Bank of England extended a special liquidity program set to expire next month, and the Bank of Japan injected another 3 trillion yen into its banking system. Such efforts followed offers of additional funds earlier in the week by central banks including the Fed and the European Central Bank.

``Central banks are going to be forced to consider all options,'' said Neil Mackinnon, chief economist at ECU Plc in London.

The collapse of Lehman and the U.S. government rescue of American International Group Inc. pushed the cost of borrowing U.S. currency overnight to 6.44 percent yesterday, the highest since 2001. The cost of borrowing dollars for three months surged 19 basis points to 3.06 percent today, while the gap between the amount that banks and the U.S. Treasury pay to borrow at three months was the widest since the October 1987 stock-market crash.

Foreign Currency

Bank of Japan Governor Masaaki Shirakawa told reporters that central banks are discussing the possibility of making it easier to accept collateral for loans denominated in foreign currency. A shortage of dollars is among the most pressing problems in international financial markets at the moment, and such a policy would enable banks to use high-quality collateral priced in euros or yen, or held abroad, to obtain dollars from the Fed.

Shane Oliver, head of investment strategy at AMP Capital Investors in Sydney, said central banks ``need to be relaxing their collateral requirements'' even more. The Fed said in the wake of Lehman's fall that it will allow securities firms to use equities as loan collateral.

``We're moving toward more money for more parties for more collateral,'' said Robert Barrie, an economist at Credit Suisse Group in London.

Permanent Swap Lines

Another recommendation -- in an April report by the Financial Stability Forum, an international group of regulators Draghi chairs -- is to make permanent the temporary swap lines that allow central banks to transmit currency to their neediest counterparts. The Fed introduced an ad-hoc swap line with the ECB in December and boosted it in July, authorizing it through January 2009.

Commercial banks may also need the ability to borrow from central banks in other countries, said Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey. Banks currently can't borrow dollars from the Fed unless they have a U.S. branch.

``The fact that global banks have such large portfolios yet no direct access to central bank funding outside the U.S. has been a crucial weakness,'' Crandall said.

A prolonged crisis may mean central banks will eventually start purchasing assets outright, said Natacha Valla, an economist at Goldman Sachs Group Inc. who was formerly at the ECB. ``There is still a long way to go before they'd need to consider this,'' she said.

Unwinding Debt

Julian Jessop, chief international economist at Capital Economics Ltd. in London, says central banks may be wary of providing greater liquidity for fear it will stop financial institutions from unwinding their debt and consolidating. The ECB said Sept. 4 it will make it harder for banks to exploit its lending rules.

``Central banks may actually want to keep up pressure for banks to sort out their own problems and so step back,'' Jessop said.

Since the credit squeeze began in August 2007, many central banks have sought to keep apart the need to soothe markets and to combat inflation. They have argued that interest rates are a blunt tool for helping markets and that price pressures prevent them from cutting rates. The test of what Morgan Stanley economists call a ``separation principle'' may come if the spasms in the markets threaten to derail growth.

``The separation is getting thinner by the day, and at some point the central banks may be forced to give it up,'' said Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group Plc.
Mind you, last year when this first hit the Fed gave lines to Canada, Switzerland and EU, plus the UK, if I remember correctly. Then later at the end of 2007 they expanded those, and everyone threw tons of money into their markets. We're coming to an end to the separation principle, all right.

Are you still believing deflation, rather than
inflation, is the likely outcome ?
Deflation of asset prices? Wouldn't you describe the current situation that way?

Yes, because this much credit destruction must inevitably cause constraints to the real money supply and a credit crunch.

I know Bernanke is on record as saying that in theory you can pump as much money as much as you need to, but you can't. There are practical limitations.

In the end, it's like trying to pressurize a tire with a leak. The tire just won't hold the full pressure - the best thing is to pump it up a bit and get it to a service station.

What's being proposed in the article is not possible for a number of reasons.
Looking forward to the long post on causation.

Great blog on the economics piece.
The markets are far larger than the central banks. The banks are not going to be able to outlast the markets without extreme measures.

They aren't going to be able to inject the money by buying Treasuries; the real yield is already negative on it and the nominal yield nearly hit zero today. Natacha Valla's comment mentioned in the latter part of your post is telling -- the central banks are going to have to buy the bad assets in order to inject money into the system. His "long way to go before they'd need to consider this" is about two weeks maximum at the current pace.
At what point does the Fed and Treasury start preserving their capital ? If they don't then they
must print. If that happens who loans them money ?
is it monetary checkmate ?
Off topic but perhaps relevant to the last couple days extreme price/yield actions. Think of all the swaps transactions Lehman was involved in. While the dealer community was able to do some netting, outsiders weren't. When the bk was declared every one of their end users needed to re-initiate their positions through a new dealer. a lot of new receivers of fixed have emerged in the last couple days...

love your work & mind...anon
Anon 4:58 - Well, the simplest answer is that all those claiming that the US would inflate their way out of this fix were ignoring a plain fact - the US has huge internal debt coming in the form of entitlements, and it must cover that with a substantial amount of deficit spending and tax increases. So if the US inflates, it reduces the entity debtload and external debtload in real terms, but inflates its internal debtload in real terms, and then has to raise taxes quite a bit higher, therefore constraining economic growth, which does have an inflation-fighting effect on the consumption side.

Furthermore, the current higher unemployment has the effect of advancing Social Security shortfalls by a few years, since many of the older workers will be forced to take Social Security early.

So no, the Fed is in no position to lend money to the world's bankers in such an unlimited fashion, nor to print massive amounts of money.

The only cure for this counterparty distrust is to reroute the flow of money through guaranteed pool arrangements. That, in the end, is what the Fed will do. It cannot do it for the world.

Treasury just swallowed up a heap of those Fannie bonds. It will get paid around 5%, guaranteed, and it can lend short in the form of T-bills. Thus Treasury just grabbed hold of the long-short financial engineering mechanism. The FRB is taking junk debt, equities and everything but the kitchen sink to turn around and lend that money back out. Essentially, our central bank has become a clearing house to ensure the liquidity. It stands between all these counterparties.

The other fixes are to put the credit default swaps on a regulated exchange, and regulate leverage allowances of all these entities now borrowing from the Fed. That will limit leverage and prevent some of the worst excesses.

The reason these people are saying that the US should do it for everyone is that money is drying up worldwide. However the Fed cannot afford to do this for institutions outside the scope of its regulatory arm.
Anon 5:28 - indeed. I am wondering who got the business? My guess is GS, mostly. It is no fun to be paying for swaps when you are not sure that your payee will be around next year.

However, that is why I am so leery of GS. It has some quite extraordinary gems of risk stuck in level three.
John - there is no way for the CBs to outlast the markets. They have to force a lot of debt destruction.

There isn't enough money in the world to support CA house valuations at the loan levels. It cannot be done.
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It will be deflation, already in the system from falling wages. You can see it all around you if you look. One of the striking things about the Great Depression is that there literally was no money. We are seeing the start of this now. I've read a lot about the Depression, from every viewpoint I could find. The more I read,the more I could see parallels. I had a great cookbook from that era, interspersed with stories. They talked about canning weeds (probably greens like lamb's quarters.) There was another story about someone that was offered a farm, but refused to take it.

Unfortunately, you can't purge depressions from the economic cycle. Just our bad luck to be around when it starts to fall apart.
Teri - you can probably purge depressions from a strongly regulated banking system, but you can't purge recessions.

Your comment is astute. One of the main components of the GD in the US was that over the previous few years, the average farmer had seen his income drop by about half. Back then the majority of the population still farmed.
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