The Markets Always Work, Let Them
It has been said repeatedly over the last several weeks that the credit market is not functioning and that government intervention is required to repair the damage. It seems more likely that the government intervention is what is keeping the market from functioning normally. Considering the massive interventions of the Federal Reserve and Treasury Department over the last year it is a wonder that the market is functioning at all. Every government action has had unintended consequences. The market has had to adjust to each intervention in its attempt to purge the excesses caused by the reckless monetary policy of the last two decades. The government may be able to delay that process but it cannot stop it.
Alan Greenspan’s easy money policies throughout the 1990s, continued by Ben Bernanke, are the source of the credit crisis. There were other factors such as the market distorting actions of Fannie Mae and Freddie Mac, but the primary culprit can be found in the actions of the FOMC. The market responded to the price signals given by the Fed and loaned money that the Fed deemed nearly worthless. When the price of anything is held artificially low the logical result is a future shortage. Thus we now have a shortage of credit just as one would predict based on past experiences with price controls.
The repeated interventions of the Fed and Treasury over the last year have accomplished little but to delay the natural, evolutionary nature of capitalism. Capitalism thrives on the creative destruction described by Schumpeter and while that process can be disruptive, it is necessary to the long term health of the economy. Failure of poorly managed financial institutions should not to be lamented but rather cheered. The failure of Washington Mutual moved assets and customers to the better managed JP Morgan. Customers will be better served and capital will be lent more wisely. Why would policymakers want to thwart that process? It would seem desirable and more logical to encourage the process rather than impede its progress.
Government attempts to delay the market process have merely caused other problems. The TAF allows banks to borrow from the Fed for periods of 28 and 84 days anonymously (using dubious collateral) and at rates below the market clearing price. The last TAF auction had a stop out rate of 1.39%. Is it any wonder that banks aren’t willing to lend in an unsecured market when they can’t determine the credit worthiness of the borrowers? Is it any wonder that banks aren’t willing to borrow in the interbank market when the Fed is willing and able to lend at a lower rate? The rates in the LIBOR market are higher for a reason. That is the penalty the lending banks demand for the lack of balance sheet transparency. The LIBOR market will return to normal when the bad banks are removed from the system and the Fed gets out of the interbank market.
The move by Congress to raise the FDIC insurance limit to $250,000 will also delay recovery. A movement of deposits from questionable banks to the obviously healthy institutions is a natural response by depositors to the uncertainty. That is merely the market acting to allocate capital in an efficient manner. Raising the insurance limit short circuits this allocation process, makes the economy less efficient and increases the likelihood of reckless lending in the future. It also extends the time it will take to achieve the trust everyone is so anxious to restore.
The Treasury action to inject capital into the largest banks last week was cheered by markets, at least for a day, but even this action would not have been necessary if the Fed hadn’t done such a good job of hiding the identity of the bad banks. In an environment where it is hard or impossible to identify the troubled institutions, the market demands a premium to provide capital to the industry. Now the Treasury will take capital from private hands by issuing bonds and inject it into the favored institutions on better terms than would the market. One should be skeptical that government bureaucrats will make wiser decisions than the market on how capital is best allocated and at what price. At least Paulson seems to have heeded the words of Bagehot for now: “Any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.”
The Fed’s various liquidity provisions are not having the desired effect because the problem is not one of liquidity but solvency. Paulson has now forced capital on the nine largest banks and admonished them to not hoard it. Let’s hope he gave them each a list of target banks and instructions to get some deals done. That is the best use of the new capital. More lending will not be of much use to a system drowning in debt.
The Fed’s special lending facilities are scheduled to end early next year. The Fed needs to make sure the market understands that they will not be extended again. That will give some urgency to the banks that need to raise capital or find a merger partner. When the undercapitalized banks are removed from the system, then, and only then, will the lending markets return to “normal”.
Change can be a disorienting process, especially in a world of instantaneous communication. Modern financial innovations such as Credit Default Swaps add information to the market and speed up the process of identifying companies in trouble. Failures such as Bear Stearns and Lehman that might have once taken years, now take mere months. We should not bemoan that fact but celebrate the efficiency of such a system. Slowing this process may be comforting, but it only prolongs the transition to a better economy. Why would we want to do that?