Monday, April 21, 2008

Green cheese factories fight excess demand for the moon – let sovereign wealth funds rescue!

Keynes likened a central bank to a green cheese factory under public control. In Chapter 17, ”The essential properties of interest and money”, of the General Theory, he emphasized the combination of three characteristics of money – via their effect on the money rate of interest - to cause contraction of output and employment at the emergence of an excess demand for money.

“Through the working of the liquidity-motive, (money) rate of interest may be somewhat unresponsive to a change in the proportion which the quantity of money bears to other forms of wealth measured in money” and “money has … zero (or negligible) elasticities both of production and substitution” (p. 234).

“Unemployment develops, that is to say, because people want the moon; - men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. central bank) under public control” (p. 235).

Where does the excess demand for money stem from? In my understanding, it is the same as the source of de-leveraging.

Fifteen years ago we, in the Government Guarantee Fund established to tidy up the banking mess in Finland, fancied the US system of securitizing the loan books of the banks to transfer credit risks to the ultimate investors as insurance companies, pension schemes, mutual funds and other agents of the end savers.

But, the occurrences in the USA show that the credit risks were not totally transferred outside the financial intermediation sector, but mostly remained therein. The reason is that the risks were only wiped off the balance sheets to the SIVs (Structured Investment Vehicles). They financed the long-term loans by issuing short-term commercial paper to the ultimate investors, that is, by applying even a riskier maturity transformation strategy than the banks themselves which originate mortgages.

As the ultimate investors started to suffer losses on the mortgage-backed securities they had purchased, they grasped to be exposed to the same credit risks via commercial paper of the SIVs. To limit their losses, the investors refused to no longer buy the SIV commercial paper; they would rather hold truly liquid assets that will bear no capital loss as short-maturity treasuries. Hence an excess demand for liquid cash started, but it was endogenously magnified by another feature of the SIVs that they had credit lines from their parent banks. Who else would have re-financed the mortgages in the SIVs?

So the SIVs had to draw short-term finance from their parent banks as soon as their commercial paper market started to dry up. The same commercial and investment banks that previously parceled loans into securities are now writing down those loans, that is, the credit risks were effectively not transferred from the balance sheet of the financial intermediation sector.

Hence the US, UK and also partly Eurozone markets are in the state of an excess demand for “the moon” which cannot be choked off! The Fed, the BoE and the ECB all try “to persuade the public that green cheese is practically the same thing” by swapping government bonds for mortgage securities to kick-start bank lending, that is, by socializing the credit risks of the underlying mortgages.

“Green cheese”, unaged cheese, is near money created by the financial intermediaries.

But, aren’t these measures rather an attempt to prevent from scoring an own goal without changing the long-term strategy of monetary policy? The central banks all behave today as if the nominal quantity of liquidity were fixed as under the gold standard in Keynes’s mind and follow his advice (p. 234): “The only relief … can come from … an increase in the quantity of money, or … a rise in the value of money”, the latter meaning a decline of money rates of interest on commercial lending.

The interbank rates of the eurozone are ¾ of a percentage point higher than the steering rate of the ECB; the interbank three-month dollar rate is more than half a percentage point higher than the Fed’s steering rate and almost a full percentage point in the case of the pound sterling.

The spread of the corporate bond rates over the steering rate is almost four percentage points for the dollar, almost three percentage points for the pound while only one and a quarter percentage points for the euro. The eurozone suffers from the global banks’ access to the Euribor market via their subsidiaries therein which Sweden avoids.

Excessive rate of expansion of financial intermediaries was the true cause of the ultimate investors’ losses on mortgage securities. The US banks advanced credit to 20 percent over the value of the asset purchased, benefiting from the interbank rates of interest of one to two percent, but in the end fished too many customers who could not afford servicing their loans.

Why to venture the taxpayers’ money? Such an approach only induces the banks to walk on stilts until the next round of socializing credit risks.

Money is currently flowing to oil-producing countries at the rate which is more than enough to recapitalize all ailing US, UK and Eurosystem banks by the next Labor Day? In the end, only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.

Such a market-driven event, secretly and quickly implemented, would enable The Fed, the BoE and the ECB to score against inflation and, in a way, would represent their “hand of God” goal.

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