The Liquidation Trap

This piece by Tom Palley is interesting and a bit of a counter point to some other posts on this blog . He stresses the danger of populist opposition to “bailing out the bankers.” Tom’s blog is at:

http://www.thomaspalley.com/?p=130

The Liquidation Trap

The U.S. financial system is caught in a destructive liquidation trap that has falling asset prices cause financial distress, in turn compelling further asset sales and price declines. If unaddressed, it risks sending the economy into deep recession – or even depression.

Current conditions are the result of bursting of the house price bubble and the end of two decades of financial exuberance. That exuberance was fostered by a cocktail of forces.

First, economic policy replaced wages and productive investment as the engines of growth with debt and asset inflation. Second, greed and free market ideology combined to promote excessive risk-taking and restrain regulators. This was encouraged by audacious claims that mathematical economic models mapped reality and priced uncertainty, making old-fashioned precautions redundant.

Recognition of the scale of financial folly has created a rush for liquidity. This is causing huge losses, triggering margin calls and downgrades that cause more selling, damage confidence, and further squeeze credit. That is the paradox of deleveraging. One firm can, but the system as a whole cannot.

Having failed to prevent the bubble, regulatory policy is now amplifying its deflation. One reason is mark-to-market accounting rules that force companies to take losses as prices fall. A second reason is rigid capital standards.

Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses. Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines.

Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.

This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.

Later, regulators must tackle the underlying problem of price bubbles. Currently, central banks are only able to control bubbles by torpedoing the economy with higher interest rates. New flexible measures of control are needed. One proposal is asset based reserve requirements, which systematically applies adjustable margin requirements to the assets of financial firms.

The Fed must also lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction.

Fears about a price – wage inflation spiral remain misplaced. Instead, the threat is deep recession triggered by the liquidation trap. If inflation is a wild card, now is the time to use the credibility the Fed has earned. Emergency rate reductions can be reversed when the situation stabilizes.

The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about “bail-outs”. Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.

At the moment the Fed is protecting banks and the treasury dealer network but leaving the rest of the system in the cold. That is perverse given how the Fed went along with expansion of the non-bank financial system. Instead, the Fed should consider an auction facility that makes longer duration loans available to qualified insurance and finance companies too.

The facility’s guiding principle should be an expanded version of the Bagehot rule. Accordingly, the Fed would auction funds at punitive rates, with loans being fully collateralized. The goal should be to facilitate repair of distressed financial companies with minimum market disruption and at no taxpayer expense. By creating an up-front facility, the Fed can get ahead of the curve and reduce need for crisis interventions that are always more costly and disruptive.

Among financial conservatives there is a view that financial markets deserve punishment for their “sins” and only that will cleanse them. This view is often presented in terms of need to restore market discipline and stay moral hazard.

The view from the left is strangely similar, arguing Wall Street “fat cats” need to be punished. Asset prices should fall, banks must eat their losses, and all but the most essential financial firms should be allowed to fail.

Both views have a moralistic dimension, and both risk unnecessary economic suffering. The mistakes of the past cannot be undone. All that can be done is to minimize their costs and then truly reform the system so that they are not repeated.

Copyright Thomas I. Palley

One comment

  • I agree that something must be done and it is quite evident with the above article as the US could face some dire consequences if fluidity is not restored within the financial sector.

    From all the various readings and things I have heard it is all about the fact that everybody is facing the fact that the bills must be paid, and when dealing with fictions such as derivatives, hedge funds, asset backed paper, other trading vehicles that does not require one to actually be sanely leveraged, there is a point where all must be paid, and this can happen especially when panic strikes, there is not enough money in the system to allow this. It is always a risk with such leveraged irrationality and right now, we are at that point and because a lot cannot be paid the trading vehicles are not worth the paper they are written on because everybody owes right now.

    And because they all owe at the same time, it has accelerated the depreciation in value. If the US government bought up the worst of the lot, i.e. the riskiest in terms of future value, it would free up some money within the system and allow transactions to flow somewhat better. Will it actually work, it is unsure.

    The problem I have with this article, is yes it is clear we have problems, but the problems presented are one dimensional. When someone writes about this crisis, not to include a word on the many people who are losing there houses and that which faces the working people, is absurd. And that is precisely why the US government is having a hard time passing such financial bailout bills.

    It is the one sided viewpoint. Sure the economic fallout from not acting will influence working people, but at the sametime, if you are going to spend such money, it would have been nice to see a few things occur.

    One the industry come out and make a pledge that abusing such new programs of bailing out will followed through.

    The industry would really appreciate such a bailout and needs it, nobody but government seems to be speaking for the industry. The only thing that seems to be done on that front is how this package is essential for the livelihood for working people. BAd sales job by the industry.

    Something substantive should have been offered up to the effected home owners facing financial difficulties issues. (Bad sales job again, but hey its the US, the rich are used to being arrogant)

    Much more could have been done, rather than simply threatening the working class with the big stick of what would happen if the proposed $700 billion was not paid out.

    It is quite arrogant of the financial system to think that it is all just about them and how jammed up they have allowed the system to become.

    Paul

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