Wednesday, July 13, 2011

Fed shows that liquidity toolbox cannot solve solvency crisis

As predicted under the FDR Framework, the only cure for a solvency crisis is disclosure.  This was confirmed by an article in the Wall Street Journal that discussed how the Fed has run out of tools in its liquidity toolbox to restore functioning lending and capital markets.

To regular readers it is no surprise that liquidity did not solve the problem.  The lesson learned from the credit crisis by both lenders and investors was not to blindly chase yield when the Fed keeps interest rates down.  $4 trillion in losses tends to concentrate the mind even when the Fed pursues zero interest rate policies.

Ultimately, if lenders are going to lend or investors are going to invest, they need to be able to access all the useful, relevant information in an appropriate timely basis so that they can analyze this information and adjust the price and amount of their exposure to reflect risk.

Without disclosure, lenders are reluctant to lend and investors are reluctant to invest.

Or as Yves Smith said it so nicely in a post on NakedCapitalism,
Making money cheaper is not going to make anyone want to take risk if they think the fundamental outlook is poor. Except for finance-intensive firms (which for the most part is limited to financial services industry incumbents), the cost of money is usually not the driver in business decisions, Market potential, the absolute level of commitment required, competitor dynamics and so on are what drive the decision; funding cost might be a brake. So the idea that making financing cheaper in and of itself is going to spur business activity is dubious, and it has been borne out in this crisis.
The only way to get the global economy going again is the restoration of confidence and the only way to do that is through the provision of disclosure.
Minutes from the Fed's last meeting, released Tuesday, seem to leave the door open to further extraordinary actions by the central bank should the economy continue to weaken... 
[J]ust what exactly could—and should—the Fed do at this point? Its target lending rate is already parked at zero. The Fed just completed a second round of buying government bonds in hope of providing additional stimulus to the economy. 
And the punch bowl isn't totally empty: the Federal Reserve continues buying Treasurys to keep the size of its balance sheet steady rather than allowing it to contract as mortgage holdings mature. 
Yet the results of these extraordinary efforts have been mixed. Deflation fears might have receded but were replaced by a spike in food and gasoline prices that has also undermined domestic growth. Meanwhile, the unemployment rate has actually risen of late, to 9.2% in June from 8.8% in March....
The reality is that the Fed simply doesn't at this point seem to have the right set of tools to fix what ails the U.S. economy. Even though interest rates have been pushed to historically low levels, demand for loans remains tepid. Other measures, such as lowering the 0.25% rate the Fed pays banks on their excess reserves, aren't likely to spur much activity. 
"The well looks dry," says Credit Suisse equity strategist Douglas Cliggott. 
Further efforts by the Fed to manipulate economic behavior and markets aren't likely to be effective, he added. 

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