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Sunday, August 12, 2012

Transcript: 513 Weinberg on Europe

Today on the podcast, Carl Weinberg of High Frequency Economics on the potential crisis in Europe, but first Dean Baker on LIBOR, Nouriel Roubini on American Pie -- in the Sky, and Mitt Romney on vice presidents

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513 Weinberg on Europe

from Dean Baker

The case of the rigged Libor turns out to be the scandal that just keeps on giving. It reveals a great deal about the behavior of the Federal Reserve Board and central banks more generally.
Last month, Federal Reserve Board Chairman Ben Bernanke gave testimony before Congress in which he said that he had become aware of evidence that banks in England were rigging the Libor in the fall of 2008. According to Bernanke, he called this to the attention of Mervyn King, the head of the Bank of England. Apparently Mervyn King did nothing, since the rigging continued, but Bernanke told Congress there was nothing more that he could do.
The implications of Bernanke’s claim are incredible. There are trillions of dollars of car loans, mortgages, and other debts, in the United States, tied to the Libor. There are also huge derivative contracts whose value depends on the Libor at a moment in time. People were winning or losing on these deals not based on the market, but rather on the rigged Libor rate being set by the big banks.
Bernanke certainly had an obligation as Fed chair to expose and stop this rigging, which was interfering with the proper working of U.S. and world financial markets. But hey, Mervyn King didn’t want to take any action, what could Bernanke possibly do?

It is truly incredible that Bernanke would make such a statement to Congress and the public. There was nothing he could do about the rigging?

American Pie in the Sky
by Nouriel Roubini
From Project Syndicate:

While the risk of a disorderly crisis in the eurozone is well recognized, a more sanguine view of the United States has prevailed. For the last three years, the consensus has been that the US economy was on the verge of a robust and self-sustaining recovery that would restore above-potential growth. That turned out to be wrong, as a painful process of balance-sheet deleveraging – reflecting excessive private-sector debt, and then its carryover to the public sector – implies that the recovery will remain, at best, below-trend for many years to come.

Even this year, the consensus got it wrong, expecting a recovery to above-trend annual GDP growth – faster than 3%. But the first-half growth rate looks set to come in closer to 1.5% at best, even below 2011’s dismal 1.7%. And now, after getting the first half of 2012 wrong, many are repeating the fairy tale that a combination of lower oil prices, rising auto sales, recovering house prices, and a resurgence of US manufacturing will boost growth in the second half of the year and fuel above-potential growth by 2013.
The reality is the opposite: for several reasons, growth will slow further in the second half of 2012 and be even lower in 2013 – close to stall speed. First, growth in the second quarter has decelerated from a mediocre 1.8% in January-March, as job creation – averaging 70,000 a month – fell sharply.
Second, expectations of the “fiscal cliff” – automatic tax increases and spending cuts set for the end of this year – will keep spending and growth lower through the second half of 2012. So will uncertainty about who will be President in 2013; about tax rates and spending levels; about the threat of another government shutdown over the debt ceiling; and about the risk of another sovereign rating downgrade should political gridlock continue to block a plan for medium-term fiscal consolidation. In such conditions, most firms and consumers will be cautious about spending – an option value of waiting – thus further weakening the economy.

Last time we took a look at monetary policy with Tony Dwyer. We didn’t play idiot of the week theme music then because we respect Dwyer’s intellectual consistency and commitment to his thesis. Which broke down at the point where he contended that economic activity is fomented by Fed interest rates. We agree that this is how markets see it and react, but the evidence is lacking in the form of actual economic activity being produced. Money is produced in the lending process. Lending is generated not by having cash near at hand, but on the prospect of profit. Conversely money is destroyed in the debt deflation process, deleveraging, under the prospect of loss.

Here with Weinberg we see again intellectual consistency and coherence., plus a keen eye on what is actually happening, but it breaks down again at the point of credit creation. here Weinberg says Europe needs a TARP. He’s right that it is all about the banks, and we’ve said that here at Demand Side from the beginning. And he is right again about the foolishness of trying to reflate the bond bubble. (Though we not with respect to the U.S. that -- however foolish -- the Fed (not the Treasury) did try to reflate the MBS market. The evidence is still on its balance sheet.) But Weinberg is not right about the effectiveness of the TARP scheme. Pointing to some green shoots in the US in C&I -- commercial and Industrial -- lending, he neatly avoids the fact that it has been a long time coming. The exposure of the US to Europe is much more serious than this kind of bad smell he alludes to. The US recovery is as much or much more a result of the non-austerity program of trillion dollar deficits and the cheap funding from having a safe haven currency than it is the TARP. The rescue of the banks has been a failure to enforce market discipline, or any kind of discipline, on a sector which is demanding discipline and sacrifice from everybody else. It is the banks who are in charge. Hence the present stagnation and the perilous future.

Liquidity is often talked about, but rarely defined. When you hear “liquidity is sloshing around,” you -- or at least I -- have a vision of money, dollar bills, looking for this or that asset to buy.

And indeed cash is the most liquid asset. One can imagine, however, a situation where its price can -- say in terms of water in the desert -- change.

The point is the essential quality of liquidity is that the thing can be bought and sold easily without changing the value. Stocks and bonds with deep markets are liquid. Real estate in a depressed market is not liquid.

When the central bank provides liquidity, it is loaning money against collateral that in the present condition cannot be sold at normal prices. It is not buying the asset outright, unless you are the Fed, but loaning against collateral, so the asset does not have to be sold into a falling market, an illiquid market.

“Lend freely against good collateral” is the central bankers slogan in times of crisis and one that Ben Bernanke has quoted.

The question becomes, “What is good collateral?” How do you know if you have an illiquid market or a worthless asset?

With mark to market, which legitimate accountants insist upon, the asset wants to be valued against a current market price. With extend and pretend, banks and others seek to hold onto assets at higher valuations until some time in the vague future that the market comes back. Betwen them is the question, Are the markets illiquid or is the value of the asset just not what you want it to be?

Since decisions about the value of collateral have been made in the heat of crisis, there is no doubt that the drive to provide liquidity has led assets to be valued above their market price and loans extended on this value.

So we get to solvency. Is the value of assets higher than the value of liabilities? Now we do not pretend to understand the nuances of finance, but we do see short- medium- and long-term. The cash from the loan is an asset. The loan is a liability. If the collateral value goes down, you’d better have kept the difference in some form, otherwise -- say hi , American hhomeowner -- you are under water.

Then you have a market which becomes illiquid and there is no collateral to loan against. See the MBS, mortgage backed securities, market, where the collateral is a slice of a bundle and the underlying value is opaque. Ben Bernanke says you just buy the whole security. Not so different from a repo -- repurchase agreement -- except nobody is contractually obligated to repurchase. But the market will provide once we straighten out the quote complex chain of causality unquote that led to the housing bust.

Footnote: A repurchase agreement or repo is a contract where you sell your asset and agree to buy it back at some future date, with a price differential. It is effectively a loan agaist the collateral of the asset. That is, at the end of the day, you get cash for a specified period, and the lender gets rights to the asset, and you pay for the privilege in interest or in the difference in price.

The bad news is the Fed purchased more than a trillion in MBS’s and has become the only buyer ni the market. Now those securities are sitting there waiting for a revival. The sellers have their money. The Fed doesn’t talk about it.

At the tmie, baffled Ben’s analysis was that the housing bust was generated by quate a complex chain of causality” unquote in which one market didn’t support the next. He would step in and provide the support to the critical link in the chain and keep the whole thing from falling apart, and yes the market would reflate.

Ooops, it wasn’t a chain. It was a bubble. The bubble popped. You can’t reflate a popped bubble. That doesn’t seem to keep Ben off the pump, though, buying mortgages, reducing rates, etc., etc., in hopes one day those securities will be worth what he paid for them.

Just a couple of notes before we wrap up. Walter Bagehot (that’s B-A-G-E-H-O-T, prounounce Badget) originally said in the 1860s or 1870s, the central bank should lend freely against good collateral at punitive rates, so as not to be subsidizing the borrowers. The Fed has forgotten a couple of the adjectives, and the collateral is now dodgy and the rates are concessinoary, not punitive. This provision of liquidity has become another activity of the Fed in its role, as former SEC chairman Arrthur Levitt calls it, the Bankers Protective Association.

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