The turmoil in financial markets is eliciting the usual response from the central bankers, all up there in their Hueys, ‘Die Walkuere’ blasting out of their beat boxes. But the fixation on the ‘sub-prime’ angle and on the Fed’s role in isolation only tells part of the storyWhile wholly in agreement with the overall thesis of a credit expansion gone wrong as the root of our current woes, I think some treatments of the mechanism are a little too classical and narrow.
For a start, among its peers, the Fed’s balance sheet has expanded by a much lesser amount that that of the larger ECB, while the Bank of Japan’s policy of maintaining rates at or near zero for all these yeas has also exerted an undeniably malign influence on prices.
Add to this the fact that broad money in the so-called BRIC nations (Brazil, Russia, India and China) is now almost as large as US M2 and is expanding at 20%+ a year, and that the major oil exporters are running surpluses of up to $500 billion a year which they recycle ‘without tears’, in true Rueffian fashion, and we can see that the global inflation does not have its roots entirely in the Marriner Eccles building.
Moreover, the picture of a Fed deliberately adding banking reserves, which are then expanded by a factor of ten or so, is somewhat anachronistic. Thanks to reduced reserve requirements and technological innovations (such as sweep accounts), US banks actually support $1.3 trillion of M1 and $7.2 trillion of M2 on a reserve base of just $40 or so billion – a superabundance of which is furnished by the bank notes which they routinely hold in their vaults or ATMs.
To the extent that banks today are subject to any effective restraints upon balance sheet expansion, it is to those capital ratios enshrined in the so-called Basel accords. Sadly, the fact that bank ‘capital’ itself can be instantly generated with the aid of another bank (and so is a somewhat ephemeral concept) has escaped the framers of this system.
Further, its methodology of ‘risk-weighting’ bank assets means the arbitrage between, say, holding an asset on its own balance sheet and granting perhaps 90% of the finance a pet hedge fund needs to do the same is enormous. Add to this the ability of a second hedge fund to assume further magnitudes of effective economic leverage by buying, not the asset itself, but a derivative built around it, and you can see that the Fed’s six-weekly decisions on short-term interest rates have, perforce, lost much of their direct importance to the mania.
Moreover, this bubble has really been a credit bubble, not a money bubble, albeit that we must allow that this was triggered by the central banks’ rush to set historically low nominal and real official rates in the wake of the tech bubble and than (a fact largely unremarked by the Punditry) greatly extended by their desire not to ‘surprise’ the market when they re-adjusted these rates and so allowed speculators a near-exact calculation of the future trajectory of basic funding costs to persist for far too long after the first reversal.
No, far from being CB reserve-led, the real dynamic has been the result of an unprecedented boot-strapping between private equity funds; their investment and commercial bank (and now governmental) sponsors; the unparalleled profusion of hedge funds whom the latter also avidly support and promote; and the more traditional institutions who have been partly seduced (by the prevailing low yield environment), partly forced (by post-Tech crash, government regulatory insistence upon a more stringent matching of assets and liabilities) to buy the devilishly repackaged derivative structures created out of this maelstrom of leverage.
At present, it is this pyramid which is collapsing and while sub-prime may have been the occasion for the first cries of “Sauve qui peut!”, it is hardly the largest problem the markets now face, nor the real cause for the latest batch of morally-hazardous intervention on the part of the central banks.
For a further treatment of this topic, please go to:-