This article is being brought to you by Minyan Satyajit Das,
a risk consultant and author of Traders, Guns & Money: Knowns and
Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall)
as well as the author of The Super Conduit Proposal.
good times, financial markets embrace capitalism. In bad times,
financial markets re-discover socialism. Currently, the U.S. Federal
Reserve is engaged in a dangerous strategy to look after its Wall
The origins of the current credit crisis lie
in loose monetary policy and excessive capital flows that were
turbo-charged by "financial engineering" techniques used by banks.
Borrowing bought more borrowing, fueling price increases in financial
assets: debt, equity, property, infrastructure.
months, major banks have reported losses of around $45 bln on their
investments. Up to $1 trln of assets are also on their way back onto
bank balance sheets as complex off-balance sheet structures
(Collateralized Debt Obligations, conduits issuing Asset Backed
Commercial Paper and Structured Investment Vehicles) are unwound.
major regulatory response has been cuts in the U.S. Fed funds rate
(0.75% pa) and the discount rate. In recent weeks, the differential
between inter-bank rates and the central bank targeted rates has
widened to levels not seen since August. This points to further
potential cuts in both rates by the end of the year. Lower cuts are
inconsistent with above target inflation levels resulting from high oil
prices, higher food prices, increasing cost pressures in emerging
economies such as China and the potential inflationary effect of a
weaker U.S. dollar.
The U.S. central bank's strategy is clear.
The current credit problems require a substantial reduction in the
level of borrowings and leverage in the global financial system. Asset
prices ramped up by excessive debt need to adjust. The adjustment can
take place via a "crash." This would be de-stabilizing and would wreak
further havoc on already weakened banks. Alternatively, the
de-leveraging and price adjustment can be achieved by creating
inflation through loose monetary policy. If asset prices remain at
current levels, higher inflation allows values to fall in real terms.
Higher inflation also reduces the value of the borrowings that must be
paid back, allowing the required reduction in leverage.
Between January 1960 and December 1974, the Dow Jones Industrial Average
was substantially unchanged. This is despite significant periodic
rallies during the "go-go years." If inflation averaged 5% pa, then the
value of the market (ignoring dividends) lost around half (50%) of its
value in real (inflation-adjusted) terms.
The Fed strategy
also assists affected banks. The large writedowns in risky assets and
the expected re-intermediation of assets means that some banks need
large infusions of capital. Given recent performance and subdued profit
outlook, it would be difficult for them to raise this capital at
Lower short-term interest rates allow banks
to borrow cheaply. The money can be used to purchase government bonds
that provide higher returns than the cost of borrowing. This generates
profits for the bank without the banks having to hold capital against
their assets (banks generally are not required to hold capital against
government securities). The profits help re-capitalize the bank. An
added benefit is that the U.S. government can fund its deficit by
selling its debt to the banks. This would be handy if foreign demand
for U.S. Treasuries decreases in response to the weaker dollar. The
Bank of Japan used the same strategy to re-capitalize the loss, making
Japanese banks after the collapse of the "bubble economy" in 1989.
inflation expectations are already evident in higher gold prices, the
steeper U.S. yield curve (long term rates are higher than short-term
rates) and the weaker U.S. dollar. Foreign investors, especially large
sovereign investment funds, are switching from financial assets (bonds)
to "real" assets (companies with real businesses), reflecting higher
This strategy is dangerous.
Inflation can lead to a significant transfer of wealth from investors
to borrowers. Inflation once embedded in the economy distorts economic
activity such as investment and savings. The experience of the late
1970s and early 1980s highlights the difficulties in recapturing the
inflation beast once it is uncaged. Paul Volcker, then Chairman of the
Federal Reserve, bravely increased interest rates to stratospheric
levels to squeeze inflation out of the financial system.
strategy may also not work. The cuts in rate do not appear to have had
the desired effect in improving market liquidity conditions. Default
risk concerns continue to inhibit lending and other routine financial
transactions. Lower rates may set off further bubbles: for example, in
equities and emerging markets. Asset prices may fall sharply anyway. In
fairness to Dr. Bernanke, he has limited policy alternatives available.
Central bankers have stated that "errant" banks and investors
will not be "bailed out." Actual actions suggest otherwise. Banks have
played their "nuclear" option well. The specter of "systemic risk,"
whether real or not, is one a central banker cannot ignore. The
strategy has attracted little scrutiny or comment despite being
implemented by unelected officials with public money and without any
transparent political debate.
In a 1998 speech during the
Asian financial crisis, Lawrence Summers, then Deputy Secretary of the
US Treasury preached the merits of American-style "transparency and
disclosure." A new term – "crony capitalism" – was coined to describe
the cozy relationship between Asian governments' regulators and the
private sector. It seems that crony capitalism is not exclusive to
The banks continue to privatize gains and socialize losses. Socialism for Wall Street will prevail, once again.