Central Banks Make No Sense to Me
The European Central Bank injected $130.6B into the money supply. Japan put in $8.5B and Australia $4.2B. The U.S. Fed put in $19B. Over the weekend, the ECB says it will add another $83.6B. This is supposed to bring stability to markets.
Did I miss something? I’m not a central banker, but it seems to me the reason for all the market instability is loose lending, right? Subprime mortgages and unsaleable private equity debt and all that.
So the solution to a situation caused by too much money sloshing around the world is to inject more money into the money supply? Does this make sense? Maybe I’m way off base on this and if so, someone please correct me.
The subprime mess was caused by lenders lending money to people who otherwise could not have gotten it. The banks had extra money sitting around without a place to go. So they lent it to poor credit risks. The fix? Give them more money to lend. Huh?
I’m no economist, so can someone enlighten me?
August 10th, 2007 at 2:24 pm
Look at it from the central banker’s perspective and not your own.
If the central banks don’t provide more money, then no one will buy anything. What do you think will happen to the planet if no one buys anything?
The central banks exist to keep themselves in business. If they lose control then they’re out of business.
Think of it this way, what good would a doctor be giving away free medicine if everyone were healthy? If everyone on the planet were healthy, there would be no need for medicine or doctors.
If we didn’t require central banker’s paper money to buy things we wouldn’t need paper money or the central bankers.
Get it?
August 10th, 2007 at 11:07 pm
takes a lot more time to explain than i have right now…but we are talking apples and oranges here….First - the “banks” did not make the subprime loans….Essentially the financial markets did. If you own a money market account, or a bond fund YOU may have actually been extending credit to subprime borrowers throught the securities and derivatives in these funds. Now - what happened this week is that banks didn’t want to lend money to HIGH credit borrowers: ie other banks. So, the central banks - as they are designed to do - stepped in and extended to credit to highly credit-worthy borrowers, which essentially saved our global economic system from some very bad things….
August 11th, 2007 at 5:40 pm
the problem was that there was suddenly far less money in the system than people thought, because mortgage-backed securities were worth far less because they never were truly valuated. you alleviate a lack of cash in the system by putting more cash in the system. thus, central banks dumping money in the system.
August 13th, 2007 at 9:17 am
Thanks for commenting, all. I appreciate your points of view. I have a general comment. I think it’s a problem when central banks only know one trick - increase liquidity. Greenspan did that when the currency crisis hit, which created the stock bubble. When the stocks popped, he did it agiain, which created the housing bubble. Now Bernanke does it again when that pops. And money generation creates price inflation.
@ muntz - I disagree. Banks do make subprime mortgage loans. Granted, not all subprime loans were originated by banks, but they most certainly do make loans. Money markets invest in commercial paper - very different from CMOs. If your point is that the money market lends money to banks who lend money to subprimes, you’re correct. But ‘indirectly,’ everyone is involved in every transaction if you follow the money back far enough.
@ Tim - I believe you are absolutely right. Derivatives are just waiting to blow up catastrophically for that very reason. You can give them any price you want. But I don’t think there’s a lack of cash. There’s just a lack of cash being loaned for private equity and buying CMOs.
August 13th, 2007 at 12:42 pm
@KMC….you actually make a good point about bubbles- we have actually had a bubble bouncing like a beach ball from one asset class to another: currencies, tech, housing…I disagree with you on the following -
1) A central bank exists for 2 reasons: to insure the stability of the value of money (protect against inflation and deflation) and insure the health of the banking system. The strongest weapon to accomplish both these goals is through the extension of credit/liquidity- both of which are essentially the same thing. They could certainly insure that no more bubbles were to exist by popping the current one, but that would have the effect of damaging the current banking system. Instead, the centreal banks have chosen to let the air out slowly.
2) Banks do MAKE subprime loans, but *generally* they don’t HOLD them, rather they sell them into the market. Also the majority of subprime loans are made by independent companies like New Century (which has now gone bankrupt).
3) Yes money market funds invest in CP. Money market funds also invest in Asset Backed CP Programs, which are very, very similar to CMOs, but these are called SIVs - Structured Investment Vehicles. These SIVs make long term loans and borrow short term (the ABCP). What goes in to the SIVs? Well, frankly anything - INCLUDING SUBPRIME MORTGAGE PAPER.
August 13th, 2007 at 2:32 pm
Muntz, I agree, that is the function of central banks. I just think pumping money into a system already awash in liquidity does the opposite of protect against inflation. That’s my real problem with the actions of these central banks. I’m kind of an inflation hawk.
BTW, you made me look at my money market prospectus again. Sure enough, there’s a disclaimer allowing them to put up to 10% of assets into “illiquid securities.”
August 13th, 2007 at 3:22 pm
KMC - you point the the fine line the Fed is treading here - preventing a bank run vs. inflating the economy. I wouldn’t worry - a couple hundred billion isn’t really that much money. Plus since it was done thru repurchase agreements it is immediately reversible, unlike an interest rate move.
Regarding the 10% - i would SERIOUSLY doubt if ABCP would count as illiquid securities. ABCP is a verrrrrrrrry common security and usually not considered illiquid. Don’t worry - the ABCP (which likely owns Subprime) has a bank backstop in case the next auction fails…back to the banks!
The 10% could be lots of other things -including some stuff that is more toxic than subprime.
August 15th, 2007 at 10:00 pm
Yes, commercial banks make subprime loans and there are responsible for much of the current subprime meltdownand yet to be determined bursting of the real estate bubble, but this little to do with why the Fed injected money into the market.
Basically monetary monetary policy affords the Fed two methods of management. One is to control the liquidity in the system (i.e. the amount of money available for lending to federal reserve banks and commercial banks). The second is through the manipulation of the federal funds rate (or the rate at which one depository institution lends money to another). Interestingly, while the Fed has direct control over the first arm of monetary policy, it does not directly control the later. The rate set by the Federal Open Market Committee is actually only a target; the real rate is set by the open market itself.
So if you’re still with me, what happened last week was that demand for dollars greatly increased as domestic and international investors fled stock markets and sought shelter in securities with a government guaranteed rate of return such as Treasury Bonds. Also contributting to the sudden decrease in liquidity was the fact that commercial traders have been shorting the euro, british pound, and swiss franc for the last two weeks, which means they were looking to cheaply acquire dollars on the open market. Given that the foreign exchange market is a multitrillion dollar market, this has much more effect on monetary policy than the meltdown of any given economic sector.
When you combine the two factors noted above, the end result is what we had last week a decrease in liquidity. This is turn caused an increase in the federal funds rate (remember this is determined by the market itself. As supply (dollars) decreased, the demand for loans (federal funds rate) increased. If I remember correctly the federal funds rate peaked at 5.45ish on Thursday evening. It also rose slightly on Monday prompting another injection of cash by the Fed.
In such a situation, the Fed has two choices. The first is to inject money into the system at a rate neccessary to maintain their target federal funds rate. Their second choice was to lower the federal discount rate, or the rate at which the fed lends money to commercial institutions and is under the direct control of the Fed vice the open market. This rate is currently 6.25%. If they cut the rate as Jim Cramer and others called for on Monday, which would cause the federal funds rate to also fall. Why? Because what commercial bank would borrow from another commercial bank at a higher rate when they can borrow from the Fed at a cheaper rate and have the added bonus of the loan being secured by the USG?
Bernake ultimately went with the first option because he doesn’t believe that the current crisis in the subprime market will spill over into other sectors of the economy. Whether this is wise assumption or not remains to be seen, but today’s core and total producer price index and yesterday’s core and total retail sales reports partially valided Bernake’s theory at inflation continues to be an issue.
Personally I think Greenspan’s maintainence of a ridiculously low federal funds rate for years followed by 17 consecutive increases, the lack of oversight of Fannie Mae, Freddie Mac (who purchase 40-60% of loans on the secondary debt market), and the Fed’s implicit authorization of such ridiculous loans a 2/28 and other ARMs as well as negative amortization loans are really to blame, but I will save that for another rate.
Very long story short, this is a layman’s explanation of why the ECB and Fed injected cash into the open market. Hope I didn’t confuse you further.
August 16th, 2007 at 7:47 am
2b, thanks very much for your insight, especially regarding the currency shorting. I appreciate it.
April 16th, 2008 at 12:11 pm
Contributing to the sudden decrease in liquidity was the fact that commercial traders have been shorting the euro, british pound, and swiss franc for the last two weeks, which means they were looking to cheaply acquire dollars on the open market.