Tuesday, January 08, 2008
considering the limitations of the federal reserve
The Federal Reserve has ample power to deal with a liquidity problem, by making collateralized loans as authorized by the Federal Reserve Act.
The Fed does not have power to deal with a solvency problem. Should a solvency problem arise with any of the GSEs, the solution will have to be found elsewhere than through the Federal Reserve.
of course, a solvency problem is exactly what we have. perhaps this does something to explain the rather limited actions of the fed and global central banks in terms of real liquidity creation, ie money printing. i noted here the massive intervention of the european central bank, but mish rightly notes here through john hussman that the move was really not what it appeared.
Despite the apparently enormous amount of last week's 348.6 billion euro “main refinancing,” the fact is that it was a rollover of existing repos, not a “new injection” of funds. What's more interesting is what didn't get reported.
At the beginning of the week, the ECB had 488.5 billion euro in net liquidity outstanding. By the end of the week, the ECB had 485.5 billion euro outstanding.
So here's the blunt truth: the ECB drained 3 billion euro of liquidity last week!
it seems to me that western governments are conducting what amounts to a massive propaganda campaign directed at investor and (more importantly) consumer confidence, and using "liquidity" as the main selling point. the best question one can ask at this moment is this: why? why are governments and their banks coordinating liquidity actions and publicizing them vociferously? why are governments coordinating attempts at private bailout funds like the failed super-SIV? and why are they doing all this with equities within spitting distance of all-time highs, and with most economists still not predicting recession?
i submit that it is precisely because said same governments question the efficacy of their circumscribed, untested and perhaps immaterial powers in the face of a deflationary credit crisis on the other side of a minsky moment, following hot on the heels of perhaps the greatest credit bubble in the history of western civilization -- one that has probably driven macro debt considerations in the united states particularly to the cusp of the zero hour. at this point, propaganda is almost certainly their most effective weapon in any effort to prolong the credit cycle.
once that fails -- and it does appear to be failing -- the potential for unwinding is very great indeed, though governments will certainly mount excessive efforts to prevent a full capitulation. if the federal reserve is eventually to engage in a massive money-printing operation, it will have to be in conjunction with a rewriting of its rules, as mish notes the fed itself understands.
The Federal Reserve could also provide stimulus to aggregate demand either by purchasing U.S. agency or private-sector debt (Section 6) or by extending loans in which such debt was used as collateral (Section 7). In both types of operations, the Federal Reserve Act limits the actions of the Federal Reserve.
For example, there is no express authority for the Federal Reserve to purchase corporate bonds or equities. And in making loans, the Federal Reserve seems to be restricted in taking onto its balance sheet the credit risk of private-sector nondepository entities.
Restrictions in the Federal Reserve Act all but rule out "money rains" by the Federal Reserve.
as poole said in relation to the GSEs but in truth by extension to private banks of all kinds:
I believe that many risk managers simply accept that GSEs are effectively backstopped by the Federal Reserve and the federal government without ever thinking through how such implicit guarantees would actually work in a crisis. The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the “someone” be identified and the “somehow” be specified.
I have emphasized before that if you are thinking about the Federal Reserve as the “someone,” you should understand that the Fed can provide liquidity support but not capital.
As for the “somehow,” I urge you to be sure you understand the extent of the president’s powers to provide emergency aid, the likely speed of congressional action and the possibility that political disputes would slow resolution of the situation.
in the end, real backstopping of the financial system will more likely have to emerge from the treasury and a direct funds injection into the banks by the direction of the white house. that is worth remembering, particularly as we are in a presidential election year.