Grist for the Mill
Many people have become anxious about the future course of the U.S. economy and financial system. How could they not, with the unremitting media coverage of companies in distress, markets seizing up, and credit conditions tightening throughout the land? If a recession were declared tomorrow, would anyone be surprised?
In fact, most economists would. Recessions are very particular economic events, requiring broad-based and persistent declines in production, spending, and employment. As of today, the U.S. economy has not shown any of these characteristics, although payroll employment did decline from July to August. Indeed, according to most of the economic data in hand, the U.S. economy has been expanding at a moderate pace, notwithstanding the residential construction sector’s drag on total spending.
So why the front page gloom and doom? Well, credit markets have become tighter for many borrowers over a wide range of financial markets. That mortgage markets have tightened up for many borrowers is not surprising; after all, lax mortgage lending standards created much of our present difficulty. But there are other reasons as well. Domestic and foreign investors, the source of the extra cash that propelled our economy in the past few years, have suddenly become deeply skeptical about some of the investment products being offered to them. They are dubious about the stated quality of those products and their liquidity. As one senior bank examiner put it, investors have gone “on strike.”
The investor pullback is posing some unique challenges to the global financial system. Many institutions have made a good living by selling financial instruments designed to meet their customers’ need for quality, price, maturity, and risk. In recent years, these instruments have become highly complex because they are claims on pools of various kinds of debt obligations (for example, home mortgages, commercial mortgages, credit card receivables, and auto loans) and the market for these asset-backed securities has become fragile. With investors less willing to acquire assets structured into these kinds of products, millions of people who indirectly relied on them for funds now must wait for financial intermediaries to obtain funds from these investors under terms and conditions unlike those that prevailed until recently.
It is proving to be quite a task. One consequence is that some borrowers cannot obtain funds at all; others can, but only at higher interest rates and on stricter terms than before. Another consequence is that some investors are only willing to commit their funds to financial intermediaries for very short periods—overnight or weekly—rather than the intervals of 30 to 180 days that were commonplace in more tranquil times. Financial intermediaries are understandably reluctant to make long-term loans on the basis of such fragile short-term funding. Some financial institutions that have plenty of secure funding are reluctant to extend credit to their counterparties who, they fear, will not be able to pay them back. Some institutions have obligations to extend credit to customers who cannot find it in the open market; in fulfilling these obligations, they reduce their capacity for lending to other customers. There is sand in the gears, and the financial transmission system needs an overhaul.
The textbook solution to this problem is fairly straightforward: Let markets re-price financial assets and the cost of risk; let them decide which financial institutions are illiquid but solvent, as opposed to illiquid and insolvent. And let central banks provide the cash the market as a whole needs as it gropes to establish a new equilibrium. If a central bank does extend credit to institutions that cannot find funding in the open market, it should require that the credit be secured by good collateral, and it should provide no subsidies.
Central bankers have learned a few things about financial market crises over the years. They have learned that in a crisis, markets may function poorly. Because accurate information can be difficult to come by, people become risk-averse; markets may seize up and credit may not flow efficiently. Consequently, central banks look for opportunities to improve on market outcomes, but they are mindful that certain kinds of interventions could lull private market participants into a false sense of security about risk management, including liquidity risk. Finally, central bankers have learned that no matter what they do, their actions will be grist for someone’s mill.
Yesterday the Federal Reserve reduced its federal funds rate target and discount rate on primary credit by 50 basis points each. The FOMC’s statement indicated that its action was “intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.” Let the millstones turn.