THE KEYNESIAN LIQUIDITY TRAP MAKES A COMEBACK

8/19/07

THE KEYNESIAN LIQUIDITY TRAP MAKES A COMEBACK

Now the “Don’t Worry, be Happy” and “Keep the Government Out of My Business until I Need Help” crowd is counting on the Fed to bail out the hedge funds and other various risk takers under the guise of “shoring up the financial system” by adding generous doses of liquidity to the system. Yesterday’s decrease of the discount rate, along with loosening terms on collateral and repayment for borrowings at the discount window, was the first, and the bulls hope, the only necessary, step in this rescue process. It’s not going to work.

Lack of liquidity is not the problem. As recently as July, we were being told, by the same experts who now wail that their friends might (Oh My Gosh!) lose their jobs if the Fed doesn’t DO SOMETHING, that the world was awash in liquidity. In fact, this worldwide ocean of liquidity was offered by some clear thinking experts as one of the reasons that the equity markets were performing so well even though the fundamentals would indicate that at least a correction was long overdue. No, the problem is not lack of liquidity; rather, it is that the world’s lenders, broadly defined, have finally sobered up after a five year lending binge. Like a drunk desperately trying to relieve his hangover symptoms overdoses on vitamins (which he should have taken before going to bed), orange juice, and other healthy staples in order to shore up his badly battered system, the world’s financial system is seeking to lend money only to salubrious blue chip credits. In the process, lenders are discovering that many of their formerly creditworthy customers were creditworthy only because they could refinance, a classic example of the greater fool theory at work. Now, with that access to refinancing cut off, these credits are being shown for what they are: overextended, overleveraged, wing and a prayer “we’ll cross that bridge when we come to it” gambles. There is not a great enough fool to lend to these types, except, of course, you and I through the beneficent offices of our government and its various quasi-autonomous arms.

Back in 1933, when the Fed finally began to realize that the money supply’s dropping by 25% since 1929 had had a major role in bringing on the Depression which was at its worst, it tried to solve the problem by injecting liquidity into the system. But it didn’t work because the liquidity went into T-bills and other ultra-safe investments. Providing liquidity does not assure that it will reach the sectors of the economy that can make things happen. Notice how, in the meeting it called to announce that it was throwing open wide the discount window, the Fed felt compelled to encourage the nation’s lenders to overlook the stigma formerly attached to discount window borrowings and borrow freely. As in 1933, the Fed is faced with a classic “pushing on a string” problem, or liquidity trap, problem. If the Fed continues to provide liquidity, it will not solve the problem; in this case, it will serve only to weaken the dollar, discouraging the people to whom we so freely send our dollars from sending them back to us. THEN we will have a liquidity problem to go with our nearly economy-wide credit problem.

Like anyone else, I could be wrong here, but this problem appears to be far from over. As I said in my 3/14/07 post, wait until it becomes apparent to the financial wunderkinds who have seized control of our economy that this problem is by no means limited to sub-prime mortgages. The truly exotic mortgage products (the interest only loans, negative amortization loans, etc.) were almost exclusively prime, or at least Alt-A, loans. Look around your neighborhood and at your neighbors’ spending habits and tell me with assurance that all these loans are just fine. And if the Fed continues to do the wrong thing, attempting to continue the decades long practice of socializing the risk while privatizing the profits, things could get worse…a LOT worse.

When the booze is flowing freely, many rational thinking people do foolish things. The next morning, their sense of propriety and shame return and they resume their normal respectable and defensible conduct. We can only hope that enough of the financial geniuses who got us into this trouble have a store of propriety and shame when sober. Many have not been around long enough for us to get a legitimate read on their behavior in a forum where sobriety, rather than debauchery, is the norm.


The Pontificator