Every week more liquidity is injected into the global banking system by the US Federal Reserve and the European Central Bank. The average interest rate paid for overnight reserves in the US has been well below the 5.25 percent per year that the Fed still publicly says is its target.
But the market for overnight reserves now appears to be divided into three segments. Banks known to be healthy can borrow at much less than 5.25 percent. But banks facing possible liquidity problems -- which the Fed wants to be able to borrow at 5.25 percent -- are borrowing from the Fed itself at 5.75 percent, as are a few big banks that want more liquidity but don't believe they could get it without disrupting the market.
Such a difference in the prices charged to "regulated banks" in financial markets is a sign of a potential breakdown. To date, the premiums charged are small: for an overnight loan of US$100 million, even a one-percentage-point spread in the interest rate is only US$3,000. That reflects the small probability that the market is assigning to the occurrence of a full-blown financial crisis with bankruptcies and bank failures. In normal times, however, there is no such premium at all.
The fact that there is even a small liquidity crunch for banks implies larger liquidity crunches for less intensively regulated financial institutions, and even greater liquidity crunches for manufacturing and real-estate companies. It is hard to imagine that manufacturers are not now postponing orders of capitals goods, and that new home sales in the US are not dropping right now.
How does the Fed deal with such a situation? Gingerly. A decade ago, former Fed chairman Alan Greenspan likened his problems of monetary management to driving a new car, having it suddenly stop, opening the hood, and not understanding a thing about what he saw. The changes in finance had been that great.
The Fed's actions have involved what former Fed governor Larry Meyer calls "liquidity tools," as opposed to interest rate-based monetary policy. The Fed hopes that it can handle the current situation without being forced to rescue market liquidity by cutting interest rates and thus giving what it fears would be an unhealthy boost to spending. The Fed still hopes that liquidity and confidence can be restored quickly, and that this summer will serve future economists as an example of how de-linked financial markets can be from the flows of spending and production in the real economy.
I think that the Fed is wrong: The fallout from the current liquidity panic means that a year from now we are likely to wish that the Fed had given a boost to spending this month.
The reason is that healthy spending and production no longer depend only on the soundness of the banking system and public confidence in its stability. Nowadays, the banking system is much larger than the set of institutions formally called "banks" that are intensively regulated by central banks and treasuries.
A bank, at bottom, is something that (a) takes deposits, (b) provides loans, (c) pretends to its depositors that their money (its liabilities) are more liquid than its assets, (d) collects net interest as a result, and (e) gets away with it almost all the time. The deposits can be individuals' paychecks and the loans can be to small businesses. Or the deposits can be consumer paper issued by KKR Atlantic Financing, and the loans can be CDO sub-prime mortgage tranches that KKR Atlantic holds in its portfolio. Or the deposits can be investments in D.E. Shaw's funds and the loans can be the complex derivatives that make up D.E. Shaw's portfolio.
In all these cases, the liability holders -- i.e., the depositors -- have been promised liquidity, yet that promise cannot be kept if it is ever doubted. It is being doubted now.
Central banks should not focus only on keeping markets liquid. In the future, even liquid markets will be willing to intermediate fewer transactions than they were two months ago. So central banks must also focus on how the fall in the volume of money flowing through financial markets will affect spending, and on how much they should cut interest rates and expand money supply to offset these effects.
J. Bradford DeLong is an economics professor at the University of California at Berkeley. He was assistant US Treasury secretary during the Clinton administration.
Copyright: Project Syndicate
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