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3 When the big guns fail, call in
China By Julian Delasantellis
either have to get an emergency
loan from a wealthy private citizen (such as J P
Morgan in the US, or the Rothschild family in
Britain), or it would go under.
This was
the cause of the grossly amplified economic booms
and busts of the world's capitalist economies
leading up to the crash of 1929. With the 20th
century came the realization that this function,
ensuring the stability of the financial system as
a whole, best resided with the government, since
its proper operation
benefited the nation as a
whole.
The aftermath of the "Great Panic"
of 1907, wherein the US economy was only saved
from the deep depression it would face 22 years
later by the intervention of J P Morgan, led
Congress to pass the Federal Reserve Act in 1913.
The Bank of England was created in 1694, but it
was only under the governorship of Sir Montagu
Norman, beginning in 1920, that its function
changed from a commercial bank, charged with
making a profit, to that of a central bank,
charged with maintaining the viability of the
system as a whole.
Much like Pig Pen in
the Charles Schulz comic strip Peanuts,
sometimes a situation arises where there is one
bank that the other banks just don't want to play
with anymore. Nobody wanted to play with Pig Pen
because they were afraid that the cloud of dust
that encased him might rub off on them; likewise,
nobody wants to lend to an alleged weak bank,
because they fear that the cloud of possible
insolvency that surrounds it may affect them, in
that their loans to that bank would not get paid
back.
Before modern central banking, these
banks would close. That would then threaten with
insolvency the banks to which the closed bank owed
money; if those banks closed, then their creditors
would be in jeopardy, and so on and so on, until
the whole banking system was in jeopardy. In
economic jargon, this type of crisis is called a
"contagion", and it's a very apt metaphor: like
someone sneezing in a hot, crowded elevator, one
institution's sickness can make a lot of others
very sick very fast.
Here, the central
bank moves in, acting as the "lender of last
resort". It, when no one else will, can lend to
the first threatened bank. The interest rate it
charges to these banks is called the discount
rate, and it was that rate that the US Fed lowered
on Friday morning.
The rate was cut 50
basis points, a half of a percentage point, from
6.25% to 5.75%. This is still 50 basis points
above the standard interbank lending rate, the
Federal Funds target rate, which has stood at
5.25% since June 2006. This is deliberate - the
discount rate is supposed to be what is called a
"penalty rate", like a teen asking Dad for money
and getting a lecture along with the cash, the Fed
wants to be available, but not an easy touch.
This crisis seems tailor-made for
discount-rate lending and borrowing, at what is
metaphorically called the discount window. (There
is no actual teller wearing a green eye-shade
behind something with the words "Discount Window"
at the Fed headquarters on Constitution Avenue in
Washington. All these transactions are effected
through electronic funds transfer - EFT.)
Those commentators who say this entire
crisis is overblown, that the world is still awash
with liquidity, are correct, up to a point. There
continues to be huge supplies of liquidity in the
world's markets. The problem is that a lot of
financial institutions now need some immediate
contact with some of that liquidity, and are not
getting it. One of those might be Countrywide
Financial, the largest US mortgage lender.
Countrywide's stock has declined 60% in a month,
and it burned through its entire $11 billion
emergency line of credit in a few hours on
Thursday. Thus the Fed discount-rate move on
Friday.
Soon we'll get data from the
Federal Reserve that show how liberally the
threatened banks used the now more reasonably
priced discount window but, as for Friday, the
market's reaction to the rescue move was, "Is that
all?"
There is no evidence that the
freeze-up in the commercial-paper market has
thawed as a result of the discount-rate cut.
Three-month Treasury bill rates did bump up, and
LIBOR rates did bump down, but only nominally.
They are still at levels that would have been
associated with a serious system crisis only a
month ago. The Vix volatility index, the global
markets' fear thermometer, at 30, is remaining at
historically high levels.
On its open, the
US stock market behaved oddly. The Dow Jones
Industrial Average rallied more than 400 points,
but that was the high for the day. Midday, the
market lost almost all of its gains before
rallying again into the close, to end up with a
gain of 233 points. US television news anchors
reported these developments as if they were
auditioning for the role of John the Baptist in
their church's passion play, proclaiming the "Good
News" of an imminent salvation.
But in
reality, this rally was far from impressive,
particularly considering recent bouts of high
volatility in US and world equities. The 20-day
mean of the Dow Jones index price change stands at
155, with a standard deviation of 105. If I've
just transported you back to the yawning void of
existential horror that was your secondary-school
statistics class, the point here is that 233
points just isn't that much of a rally these days.
What does the Fed next do if the crisis,
and the equity-market selling, resumes this week?
Early-20th-century Harvard professor and
philosopher George Santayana once defined a
fanatic as someone who redoubles his efforts as he
loses sight of his goals. In that light, Bernanke
could throw in another 50-point discount-rate cut.
That, however, would put the discount rate even
with the Federal Funds rate, at 5.25%; that would
eliminate the penalty aspect of borrowings at the
discount window.
That opens up the
possibility of a cut in the Federal Funds rate,
perhaps at the Fed's next board meeting on
September 18, maybe sooner, perhaps after an
emergency Fed teleconference, as happened with the
discount-rate cut on Friday. A Federal Funds rate
cut delivers liquidity to the markets with more of
a scattershot approach; as yet, that doesn't seem
to be what the economy needs. It's not that the
system is short of liquidity right now; the steep
fall in the three-month Treasury bill rate proves
that. Discount-rate borrowing, targeted like a
sniper's rifle to borrowers who really need it, is
the preferred mechanism to deal with the credit
quality, not quantity, issues the markets are
dealing with now.
That's why it's such a
problem that the Fed's Friday discount-rate cut
had so little effect. If what comes out of the
barrel on firing your most powerful weapon is only
a little stick with a flag that says "Bang" on it,
your enemies, in this case the markets, will see
that there's nothing you can do to deter them, to
frighten them, to change their course of action.
Panic will set in, perhaps worse than before; past
the curtains, the smoke and mirrors, the Wizard is
seen as impotent.
Who will then be charged
with saving the financial system? Will it be the
political system, Congress and the executive
branch?
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