Thursday, October 02, 2008

Situation normal

I hope the events of the past seven days have cleared up any remaining confusion about who runs the USA. Paulson is a creature of the Treasury, and the Treasury is a creature of the banks. TARP will help banks by transferring Government money to them, but its impact on the broader economy will be negligible. Or negative.

As home prices return to historical norms, the money supply in the US shrinks (ie. the US is in deflation). While the Fed has printed money through low interest rates and a variety of other new mechanisms (all of which are inflationary), deflationary forces are still more powerful than inflationary forces. The US is in a liquidity trap (although I hate the term) as the economy needs to delever, but the monetary system does not have a good way to accommodate that. This is a fundamental failure of fractional reserve banking: it's a ratchet that can increase money supply (inflation) but cannot gracefully decrease money supply (deflation).

Bernanke knows how to stop deflation and get out of the liquidity trap: the Government simply prints money and gives it to consumers (thus the moniker "Helicopter Ben") but you'll notice that so far, the US has not done this. Most of the transfers have gone to banks, and banks are using the money to plug up the holes in their balance sheets caused by bad mortgages. So, new money is created, but banks don't lend it out. Paulson hopes that by giving banks a huge plug of money, they will finally start to lend.

I think he is certainly wrong here. His gift of $700B is not enough to plug the holes in the banks balance sheet, and it does nothing for the household balance sheet, where consumers are deep in hock and have recognized the need to pay down debt. This is Nouriel Roubini's point when he argues for a new HOLC.

Instead, Paulson's gift will create Zombie banks -- no longer insolvent (since they now have positive equity) but still not lending (as consumers cannot and will not borrow). Japan went down this path, and the result was two decades of stagnation and decline.

The one area where liquidity (the ability to roll over short term deposits to support long term debt) is really important is in the commercial paper market, where businesses take out temporary loans (30 to 90 days) to make payroll while waiting for accounts receivables to arrive. When folks talk about the Great Depression, they are talking about this market ceasing to function, and otherwise healthy businesses having to shut down. The CP market is struggling, which is the focus of all those NYTimes and NPR stories which magically began to appear, like mushrooms after the rain, on October 30th, the day after the House voted down the Paulson Plan on Oct 29th. The moral of those fables was that unless the Paulson Plan is passed, more business will struggle because they cannot borrow money from the commercial paper for their working capital. I'm sure that the Times' reporters' sources in the Treasury were very clear about how this worked. Certainly the press know how to do their job, as each headline said that it was the House that "failed", and not that a "stupid idea" had been "correctly rejected". It's great to see a plan come together.

Unfortunately, the NYTimes' sources in the Treasury are almost certainly wrong, as the Fed and the Treasury really have no idea what they are doing. This point is made clearly on Yves' blog here and here:
The bailout, I mean rescue plan, can be seen as nothing less than a new Ponzi scheme. It works like this:

Fed as only lender, in an attempt to keep the financial system from imploding;

TARP needed to keep Fed balance sheet intact so that it can continue as only lender;

Treasury will need to significantly increase the amount of Ts (public money) auctioned to fund TARP;

Panic serves to encourage T. buyers, especially for bills;

This represents a liquidity trap: TARP recipients of Ts will hoard cash to buy Ts: rinse and repeat.

This results in drying up of lending to corporations/crowding out private capital - no new credit lines;

The Fed becomes a holder of private capital, the later of which is now frozen to protect that capital from deteriorating, The rollover scheme will restrict even more lending in the private sphere for purposes of keeping the financial sphere on life support, but with the consequence of furthering the deterioration of the 'real' economy.
So, once the Fed uses TARP to buy bad bank assets, it will issues an equivalent number of treasury bills to pay for those assets, and so the quantity of treasury bills available goes up. Treasury bills are close substitutes for commercial paper, and buyers have increased demand for the safety of Treasuries anyway, so the few remaining commercial paper buyers will switch to Treasuries also (as there are enough of them to go around). This shrinks the market for commercial paper further, which starves business of working capital even more.
The problem we're having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn't make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.
This is one reason I hate all the metaphors swirling around the discussion of the financial crises -- it obfuscates the actual mechanisms in play. Paulson has given no good reason why his plan should work, and how it will benefit Main Street.

My prediction: deflation will continue through 2008 and 2009. The economy will continue to contract as consumers reduce consumption (and increase saving, which they must do) and businesses scale back operations so they fit the new, lower personal consumption environment. This will be a slow process, though, as the Fed and Treasury have worked mightily to obfuscate prices, and drag out the bubble deflation. Eventually, Helicopter Ben will say enough is enough and start to (finally) mail freshly printed greenbacks to households. Now we will switch from a deflationary environment to an inflationary environment, China will complete it's transition out of the dollar, and we will get real, honest-to-God 70s style stagflation. And then we will wait for the next Volker.


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