Thursday, October 02, 2008
unintended consequences of the TARP
The Treasury announced its auction schedule for next week and once again it will be dumping another humongous load of fresh supply on the market. The pressure on stocks and non government bonds is certain to continue as the Treasury crowding out continues week in and week out. The passage of the bailout bill, if it happens, will be a disaster, adding even more Treasury supply to a market which can’t cope with it. This is something that policy makers either fail to understand, or are ignoring.
paul krugman offered a view on financing the TARP last week. (and further here as well on recapitalization.) it could be read as a warning.
Think about what’s been happening in the markets. The public basically wants out of the private financial system and into Treasuries. But the financial system has been unable to meet that demand, because it can’t sell off toxic paper. Now, under the Paulson plan, the Treasury will buy the toxic paper, which will give the financial sector the funds to pay off debtors, who will use the funds to buy the Treasuries the feds will have to issue to finance the toxic-paper purchases.
so the net transfer facilitates the massive capital flight from things like commercial paper, corporate bonds and equities into t-bills. the net effect is to facilitate, even accelerate deleveraging -- and dry up existing sources of liquidity for risk assets in so doing, even so far down the chain as CP.
faireconomist, via yves smith (also this):
When Paulson dumps out his 700 billion in treasuries it's going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson's billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson's billions divert credit from working capital to long-term mortgages - from where it's most needed to where it's most wasted.
Even if the giveaway adequately props up the banks, which I doubt, they still can't make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.
I think it's very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson's plan will increase the supply of, say, inventory loans. It's not that every economist in the world is an idiot, it's just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson's plan falls into the category of very expensive way to hurt ourselves.
martin hutchinson of breakingviews, also via naked capitalism:
When money is tight, however, as it is likely to be for some time, withdrawing $700bn from the funding pool to support failed, past investments has a more serious effect on the economy, because capital flows are restricted by market illiquidity and investor trepidation. If that reduces asset prices, it exposes more loans to losses. If it prevents good investments by crowding them out of any chance of getting funding, it reduces economic activity. Either way, it makes the economy less efficient.
it's already been seen how central bank lending is crowding out interbank lending. how if now floods of short-end treasury issuance suck up so much available capital that the issue effectively kills remaining demand for commerical paper? for corporates? for stocks?
i for one do think that banks do have to be intervened upon in a systemic way to prevent cascading failures.
but we could be witnessing a massive policy mistake as well with the paulson plan. the details of how the TARP will actually work may make massive differences in outcomes.
moreover, there may simply be no way out.
UPDATE: ken rogoff via mark thoma.