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3 When the big guns fail, call in
China By Julian Delasantellis
In the 1939 movie adaptation of L Frank
Baum's 1900 novel The Wonderful Wizard of
Oz, all the characters were in awe of the
tremendous magisterial power of the Wizard.
Dorothy, the friends she met on her journey (the
Tin Man, the Cowardly Lion, the Scarecrow), and
all the other various citizens of Munchkinland,
they all believed that it was the Wizard, in his
castle in the Emerald City, who possessed the
powers to make all their
problems right, to make all
their lives sweet.
Then Dorothy's little
dog Toto pulled away the curtains that concealed
the Wizard's supposed magic machine, and found
only smoke and mirrors; as for the Wizard himself,
he was just a rather ordinary little man.
Last week, chance and circumstance pulled
down the curtains covering the smoke and mirrors
of the operations of the US Federal Reserve.
Behind them, instead of a magical wizard able to
contain the raging crisis now spreading across the
world's financial markets, we find the chairman of
the United States Federal Reserve, Ben Bernanke.
And his magic is proving to be as
ineffective in curing the ills of the world's
financial markets as was the Wizard's in getting
Dorothy back to Kansas.
What a difference
10 days make in the new hyper-charged world of
turbo finance.
As I noted in my August 14
Asia Times Online article Central banks' easy money, easy
virtue, it was on August 7 that the
Federal Reserve concluded a policy meeting
decrying the possibility that the gathering storm
in the financial markets necessitated a near-term
reduction in Federal Reserve interest rates. Soon
after, President George W Bush said there was
sufficient liquidity in the system to withstand
anything wicked coming out of the financial
markets.
In what must have been one of the
last plays presidential adviser Karl Rove called
from the sidelines and which was sent into the
huddle of his reliable right-wing spin machine,
the editorial page of the Wall Street Journal, Fox
News, along with commentators Larry Kudlow and
Jerry Bowyer, all said that Bush and his
laissez-faire economic philosophy had delivered to
the world an economy sufficiently robust to
withstand any challenges from the chaos spreading
out of the markets for subprime mortgages.
But in the expanse of time from those
long-ago blissfully halcyon economic days of a
week and a half ago, much of the laissez-faire
economic community has treaded a path reminiscent
of Caledon Hockley (Billy Zane) in the 1997 movie
Titanic, from first denying that there was
any problem with the unsinkable ship, to now
pushing aside women and children to get a place in
the lifeboats. As the great ship World Liquidity
raises its mighty stern into the air to commence
its slide into the sea, these previously pleased
pundits started screaming out for help from the
Federal Reserve.
And they got it, as the
Fed cut a key benchmark interest rate by 50 basis
points. But as their rescue is proving Bernanke to
be, like the Wizard, more Kansas carnival barker
than omnipotent seer, it may be creating more
problems than it solves.
There are three
main cannons in the arsenal of any US Federal
Reserve field marshal. One is called open market
operations, another is the operation of what is
called the discount window, the third is targeting
a specific level of the Federal Funds rate. In the
past 10 days, the US Federal Reserve has shot off
two of its three cannons. The first was an abject
failure; the second has had an infinitesimally
small effect. Maybe the citizens of Munchkinland
will stand for the exposure of their avatar as a
fraud, but the citizens of Moneymarketsland will
certainly not.
The open market operations
were the almost US$400 billion of reserves
injected into the world's money markets by the US
Fed and other central banks since August 8; I
described the mechanics of these procedures in my
August 14 article cited above. The results of
these procedures can probably be best described as
very expensive failures. With billions of dollars
of liquidity evaporating daily in the markets,
interest rates had been rising in the specific
money markets that the Fed and the other central
banks had influence over; in the US, the Federal
Funds rate, targeted at 5.25%, topped 6%. The
interventions settled things down - a bit - the
Federal Funds rate returned to its target range,
but other indicators of the health of the private
short-term money markets remain in very tenuous
shape.
The market in what is called
commercial paper, very short-term (frequently no
more than a day or two) corporate borrowing of
money needed to fund a company's temporary funds
shortage (or lending of funds from companies with
a funds surplus) has closed for companies thought
to have even the remotest connection with the
subprime-mortgage debt in peril; no amount of open
market operations will reach these borrowers.
If they can't find lending to fund a
short-term liquidity need, they will begin to be
pulled inexorably toward bankruptcy. Other
indicators of the health of the short-term money
markets, such as the London Interbank Offered Rate
(LIBOR), the core indicator of what has come to be
known as the Eurodollar market, are also
indicating that these Fed monetary firehouse
operations have yet to rain down on them with any
needed liquidity.
After being ensconced
around 5.30% all year, this rate climbed to almost
5.90% in the midst of the Fed interventions; that
means that wherever the money the Fed was
attempting to put in the markets was going, it
wasn't getting to the US.
So where were
the billions of dollars in Fed intervention going?
The market for US government-guaranteed
three-month Treasury bills is one short-term money
market where the Fed probably has not wanted to
have the effect that it has. Rates in this market
saw an astounding fall last week, dropping almost
130 points, to reach just under 3.6% at their lows
in the middle of the week.
Looking at this
market, you can just smell the fear permeating
world money markets; investors in the US are now
willingly sacrificing almost 200 basis points, 2%
of yield, to be able to go to bed and know that
their money will still be there next morning. This
is not the case with lending in today's
commercial-paper or LIBOR markets, where traders
just can't be sure if the counterparty they just
lent $100 million to is going to get detoured to
the bankruptcy court before the loans can get
repaid.
With the money market operations
proving as ineffective as they did, the US Fed had
to proceed to the next step, lowering the discount
rate. In and of itself, the current construct of a
free economy's central bank is a relatively recent
phenomenon. Before the early 20th century, if one
bank's impending insolvency threatened the
insolvency of the entire financial system, it
would
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