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Bernanke running out of ammo

By Julian Delasantellis

A well-worn bit of wisdom from rural America advises one that it is pointless to "close the barn door after the cows have escaped". By participating in yesterday's global round of short-term interest rate cuts, US Federal Reserve chairman Ben Bernanke cannot be said to have been guilty of this offense. Instead, what he has done is to close the barn door after the cows have escaped, been captured down the road by cattle rustlers, then sold, slaughtered and ground up into dog food chunks.

For the 10th time since August, 2007, the Federal Reserve has engineered an interest rate cut in order to counter the spreading effects of the now global financial and credit crisis. With twin 50 basis point cuts in both the Discount Rate, to 1.75%, and the Federal Funds Target Rate, to 1.5%, the Fed has now just about emptied its magazine of possible interest rate cuts.

Yesterday's cuts, coordinated across the globe with the Bank of England, the European Central Bank, the Swiss Central Bank, and the Riksbank of Sweden, with the Bank of China participating independently with cuts of its own, are the latest policy initiatives employed by desperate and besieged world economic officials to contain a truly awesome fire-breathing ogre that goes by the name of deleveraging, a monster that seems to get worse, and more importantly, laugh away all attempts to contain it, with every passing day.

It's only natural to characterize the world financial crisis by what's happening in the world's stockmarkets. Wednesday was one of those days, when from the moment the sun burst across the horizon in the Western Pacific until it waned in New York about 21 hours later, there was nothing but pain and sorrow for those learning the painful lesson that yet another mortal deity constructed of man, in this case the religion of the God of Money, had failed.

Stocks opened in Tokyo, proceeded to fall by the greatest amount since the crash of 1987 and stock trading was halted in Indonesia (as it was in Russia, Ukraine, and Romania) after its benchmark stock index, the Jakarta Composite, dropped 10% early in the trading day. Most major European indices, even after the news of the coordinated rate cuts were announced, fell by between 4% and 7%.

In the United States, the Dow Jones Industrial Average, after making a feeble attempt at a rally in the first hours of trading, was back selling off in the afternoon, closing down a further 189 points. Just since mid-day last Friday, when Treasury Secretary "Hank" Paulson's bailout plan passed the US House of Representatives, the Dow has lost 1,500 points, 14%, of its value; just since September 1, it's off 2,500 points, or just over 21% of its value.

This week marks the first anniversary of the all time high of the Dow, at just under 14,300. Since then, the market has lost 35% of its value, over 5,000 points, or almost US$9 trillion of investor wealth. For those who like their karma extra sweet, it is also the first anniversary of the premiere of the Fox Business Network, specifically established by News Corp chairman Rupert Murdoch and his consigliore Roger Ailes, to tell the story of American business that they believed the rest of the financial media were not telling, namely, that all was right and that the future looked blindingly bright, for the unregulated private sector that was at the core of American capitalism.

But world equity's trials and tribulations are nothing compared to what's going on in the credit and short-term debt markets. This, much more than stocks' travails, was what drove the trembling hands of the central bankers on Wednesday morning.

If you're an American parent of a child past puberty, or maybe if you're just an American with a very good memory, you should remember your experiences at the uniquely American form of young adult socialization called the first boy/girl dance.

In a brightly lit and decorated middle school gymnasium, you would find the entirety of that year's class of 11- or 12-year-olds. On one side of the court would be the boys, all itchy and pimply and fidgety in their first woollen sports coat, long-sleeve dress-shirt buttoned up to the adam's apple, and a striped tie, whether real or clip on, around their necks. On the other side of the court would be the girls, anxious and nervous in their own right, in their first pair of heels and hose, wearing a party dress, trimmed with frilly lace, that they were under strict orders not to get dirty.

The adults, parents and teachers, prod the two sides to get together. That was usually accomplished by means of some brave little fellow crossing the no-man's land of mid-court to ask a girl to dance. Others follow, and with that the process of inter-gender acculturation that will culminate in marriage and family has commenced.

What's going today in the financial markets is like watching a tape of a boy/girl dance in reverse. Substitute boys for borrowers and girls for lenders, or vice versa. When the dance is in full flower, the boys/lenders are interacting with the girls/borrowers, and everybody's happy. However, run the dance backwards, and the results are a lot more problematical. Gradually you'll see fewer and fewer dancers on the floor, fewer and fewer interactions between borrowers and lenders. At the end of the backward-run tape, you see the two sides completely separate and alienated from each other - exactly the way the short-term credit markets are today.

From the sunup in Asia to sundown in New York of every business day, a multi-trillion dollar dance is conducted of short-term borrowing and lending, a key component of which is called the commercial paper market.

Say an aircraft manufacturer is receiving payment for a new aircraft delivery, but does not have to make payments for payroll or for raw materials for new aircraft until next week. In the system that was fully functioning until about 10 days ago, the company, acting through an investment bank, could invest, could "buy�, short-term interest-bearing debt of other banks called commercial paper. A company that had a similar short-term funding need could issue, could "sell" commercial paper for the duration of its shortage.

In essence, this process cuts out the role of the commercial banks, since the buyers of commercial paper receive a higher interest rate in this market than they would from the banks, and the sellers borrow more cheaply than what the banks would charge.

So when short-term instruments such as commercial paper can't get sold, it's like the air that the real economy depends on to breathe is getting sucked out. Even in the face of now sometimes daily multi-hundred billion dollar world central bank infusions in the short-term money markets, banks are hoarding what short-term reserves they have - it's not going back out into the commercial paper market.

This explains the incredible drop in yield of short-term interest rates, sometimes to under 0.25%, on US government guaranteed one-month Treasury bills. Even for a loan whose term may only be a few days or less, the brevity of the loan matters little if the borrower is not around, has declared bankruptcy, when the paper is due to be repaid.

Conversely, the demand for short-term still funding exists, even as the potential supply evaporates. The demand for money raises its price; interest rates are the price of money. The various interest rates that determine the health of the short term money market, namely, the London Interbank Offered Rate (LIBOR) and the Federal Funds Market Rate (as opposed to the rate at which the Fed wants these transactions to occur at, the Target Rate) are all trading well above where their historical relationships with other market rates say they should be. LIBOR, in particular, on grim days now sometimes trades higher than it was last year, although the US Fed has cut rates, including today, 3.75% since then.

Since late April, the Federal Funds Target rate has been at 2%, but on many days during the month-long financial pandemonium we know call September, 2008, it traded significantly above that rate, past 4% or more. Getting that rate down has been the core goal of the massive fire hose of liquidity, probably now closing in on $1 trillion by now, that the Fed and other central banks have poured on the money markets these past few weeks.

But if they could barely keep the Funds Rate at 2% after putting a trillion dollars in the fight, how much less likely is it that they're now going to be able to keep it even lower, at 1.5%?

Matter of confidence

But what Wednesday's co-ordinated rate cuts could do is to restore a bit of confidence in the markets. Don't knock that; when Bernanke and Co had a chance to do that in mid-September they took a pass, and a whole lot of the world financial system's pain can be traced to events that soon followed that decision, the decision they reversed today.

In September, following the no-cut decision of the previous day, I noted how Bernanke's decision had seemed to ignore the developing crisis of confidence and solvency in the financial markets (see Ben first, economy second, Asia Times Online, September 18, 2008).

"A Fed rate cut might not have done much; it might have only bolstered confidence a bit, but, to paraphrase Jackie DeShannon's 1965 pop song 'what the world needs now is love', what the financial system needs now is confidence, sweet confidence - it's the only thing that there's just too little of ... "

But on that day the Fed said no. Then came the Paulson Plan, the 12-day legislative kerfuffle over its passage, at the end of  which the financial system emerged in a far more dire state than it was in during mid-September. There's no guarantee that a cut back then would have staved off the current world catastrophe, but, with federal funds now trading so far above the target rate, Bernanke seems to think he can instill the confidence now, with the financial system much more fragile, that he didn't think all that necessary just over three weeks ago.

But it's a lot harder getting confidence back once its gone than to just maintain it. The markets are not at all certain the rate cuts will resuscitate the short-term credit markets-thus, the aggressively underwhelming response in the equity markets following the cuts.

If the markets are now saying that the Paulson Plan is too little (even at $700 billion) and too late, and the rate cuts are like

 

spitting on a forest fire, what's left? Amazingly, the solution may involve some manner or form of government nationalization of the financial sector, and that may be coming a lot faster than previously expected.

Last week, I speculated that all the various rescue proposals being tried and then failing might not be designed to ultimately save the system, just to keep it afloat until the inauguration of the next US president on January 20. (See Crisis control fit for the TV age, Asia Times Online, October 3, 2008). Now it is possible that the required time horizons for all these band-aids and palliatives is not January, but just four weeks away - until the day after the US elections.

What is that solution? Amazingly enough, and now almost 30 years after Margaret Thatcher commenced the capitalist revolution by selling off Britain's proudest heritage of socialism, its state-owned industries, talk is returning to the prospect of a partial, or nearly complete, nationalization of the financial system - the so called "Swedish solution".

Two weeks ago, University of California at Berkeley economics Professor Brad DeLong laid out this possible solution to the crisis.

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem ... Congress grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship ... requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent.

Now it is revealed that the Paulson bailout plan passed last Friday has in its small print provisions giving the US Treasury Secretary the right to do just that, to "take" equity positions or warrants in the stock of financial companies.

And where can you hear sympathy for this Commie pinko Berkeley subversion? Believe it or not, it's on the editorial pages of the Wall Street Journal. Give this to them; they're not starting small, like proposing a partial nationalization of some small farm bank in Iowa or something. They're going for the gusto, with their eyes on the nation's largest financial institution - Citigroup.

If the feds want to prevent a full-scale rescue of Citigroup, now might be a good time to take Treasury Secretary Hank Paulson's new powers out for a spin. If Citi needs to raise capital, let the Treasury inject some, along with appropriate housecleaning on the management side and upside for taxpayers.

The Wall Street Journal advocating increased government intervention? What's next, pork sandwich recipes in the Jerusalem Post?

This approach is already under way in Britain, under the leadership of Prime Minister Gordon Brown's Chancellor of the Exchequer, Alistair Darling. The question then becomes, if the US and/or UK governments take a small ownership stake in the financial system, say 5%, and that is seen as a failure, wouldn't the natural tendency of government be then not to stop and reassess the policy, but to double down and go at it harder, say to 10%, 20 , or, finally, to 50%+1 - in other words, full control?

George Santayana once said that a fanatic is someone who redoubles his efforts as he loses sight of his goals, and, as George W Bush proved when initiating the Iraq surge, no animal on earth is as fanatical as a politician looking for alternatives to having to admit he was wrong.

In an editorial in the Wall Street Journal, Robert Pozen of MFS Investment Management suggested that, since the problem now seems to be centered in the commercial paper market, a solution specific to that sector's travails should be initiated, in that the US Treasury or Federal Reserve could guarantee transactions just in that sector.

The problem with this proposal is that it would either have to be authorized by the US Congress, which is in no way eager to take upon itself even more public displeasure with another move seen as a banker "bailout", or through another one of the Federal Reserve's remarkable unilateral interpretations and expansions of its authority.

The Fed has been doing so many of these this year, starting with Bear Stearns in March, then to the rescues of Fannie Mae and Freddie Mac and AIG, that one must wonder if Bernanke worries just how much firepower, both in terms of monetary reserves and credibility, he really has left.

Also, since the commercial paper market stretches across the globe, is the US Fed really going to backstop transactions between, say, an Icelandic bank and an Indian steel company? That's a tall order, indeed. Still, this could be a short-term strategy employed from now until the US election, after which, it is hoped, the adults might be in charge.

When the history books start to write of what has just happened in the world financial markets, I hope plenty of space is reserved for that cockeyed cowpuncher of capitalism, Mr All Hat and No Cattle himself, Dallas Federal Reserve Board president Richard Fisher.

All year long, Fisher has been warning that inflation was a bigger threat to the world economy than recession and unemployment, a contention that has now been proved spectacularly wrong. Up until very recently, he had been advocating higher, not lower, short-term interest rates, a policy recommendation that, had it been followed, and knowing what we know now about just how weak the economy actually is, would have been spectacularly harmful.

It was in September that Bernanke, evidently hoping to get Fisher back into his flock and stop his habitual dissents from the post-meeting Fed statements, agreed to the interest rate hold, when a cut could have provided far more benefit than the one we just saw.

Fisher joined in the majority with Wednesday's cut, proving, once again, that the best way to make a person see the light is to have him feel the heat. For many American senior citizens who had hoped to be able to live out their golden years gently drawing down their hard-earned stock wealth, these days they're doing both, feeling the heat and seeing the light. The heat is from the sizzling griddle at their new part-time job at a Florida McDonald's, and the light is what they see flicking off when the next basket of French fries in boiling oil is ready to be served.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

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