Wednesday, August 22, 2007

Federal Reserve Pushing on a String

Fed Confuses Supply and Demand, Confuses Problems and Solutions

Federal Reserve Fed funds interest rate cuts are dangerous because Fed policy is based on an alleged credit-supply crunch when the actual condition is a credit-demand crunch. Moreover, the crunch is the solution, not the problem. These pressures are good and necessary for economic health (like your body’s pain signal to tell you to stop doing something harmful) so Fed policy to fight them, with the wrong tools, is doubly stupid.

Being unwilling to lend is completely different from being unable to lend. If the Fed has any concern, it should be the overall availability of credit in the economy as a whole and not how the markets allocate that credit. In other words, from the Fed’s view, banks are part of demand, not supply; the Fed is the supply and “the markets” (lenders and borrowers combined) are the demand.

Less wealth, higher risk premiums, and fewer buyers mean less demand for credit in the economy.

  • It is an information crunch, not a credit crunch: The uncertainty in asset prices limits demand for credit: Investors and lenders wisely do not trust current asset pricing. Junk assets will have a market too—at the right price—but it takes time to re-price. Meanwhile, tirekickers are not buyers.
  • It is a wealth crunch, not a credit crunch: Lower asset values (less wealth) limit the demand for credit: The housing bubble bust that has occurred so far means that, even under old loan-to-value (LTV) formulas, 100% of the house today is a lower credit limit than 100% of the house last year.
  • It is a collateral crunch, not a credit crunch: The limited supply of quality collateral limits demand for credit: There are plenty of people who will offer you junk for collateral but they will think twice before borrowing--and what they are borrowing for--when banks wisely demand the family silver (a known, good value). The banks are correct to demand the family silver and the Fed is exactly wrong to accept mortgage securities to send the opposite message.
  • It is a borrower crunch, not a credit crunch: The limited supply of quality borrowers limits demand for credit: Lenders are wisely not lending to all those people who “had no business getting a loan”—especially after the media and Congress pilloried lenders for lending too much to too many. Remove many fraudsters, gambling real-estate flippers, and other unqualified buyers from the buyer pool.
  • It is a savings crunch, not a credit crunch: Higher downpayment requirements limit demand for credit: A 0% interest rate would be irrelevant at 100% downpayment requirement (no financing allowed). In more realistic terms, lowering mortgage rates from 6% to 5% will have limited impact if minimum downpayments rise from negative 5% (cash back at closing) to positive 10% or 20%. A 0% downpayment on a $500k house creates demand for $500k of credit but a 20% downpayment on the same $500k house creates demand for only $400k of credit. A global move from everything at "zero down" to everything at "20% down" would reduce total credit demand by 20%. Demand for credit further decreases when buyers who lack the cash downpayment leave the buyer pool, regardless of the interest rate.
  • It is a re-pricing crunch, not a credit crunch: Narrower bands in loan pricing limit demand for credit: More accurate pricing of risk wisely includes different interest rates at smaller increments of downpayments (10%, 15%, 20%), which has the double effect of disqualifying bad borrowers (higher rates at the lower end) and giving good borrowers more incentive to borrow less.
  • It is a "beggar thy neighbor" crunch, not a credit crunch: The “debt for you, cash for me” impulse limits demand for credit: Some of the credit demand is the hope that someone will go into debt to finance a higher price for someone else (e.g. a seller does not want credit but wants his/her buyer to have unlimited credit, whereas the buyer would prefer less credit for a lower price). Let your neighbors stimulate the economy with their debt while you collect cash and save: "I wish you had more debt and I had less debt." This non-borrowing Mexican standoff is healthy, contrary to the usual "paradox of thrift" argument (with its absurd notion that, if everyone is smart, we all suffer--and its absurd conclusion that government must force individuals to behave foolishly so the aggregate foolishness will create propserity, somehow). Our current trouble resulted from people NOT being smart and NOT doing what was in their self-interest. In the long run, you want your neighbors to be responsible and thrifty.
  • It is a risk premium crunch, not a credit crunch: An increasing risk premium limits the demand for credit: All the reasons above suggest that lenders/investors are wisely demanding a higher marginal price spread for risk (e.g. a risky borrower who used to be able to get 3% over prime rate now can get only 4% over prime rate). To keep these borrowers/buyers, the Fed would have to cut rates faster than the risk spread rises.

People wrongly infer that “credit crunch” indicates a lack of available credit in the economy as a whole when actually there is a lack of known credit-worthy investments (information crunch).

The Fed, like most government, has little power to create good investments, so it panics and hits the button it does have, to increase credit, even if that makes the situation worse. Fed Chairman Ben Bernanke treats the wise solutions of market participants as problems to be stamped out with more of the loose monetary policy that caused the predicament. Bernanke seems to know that the issue is not the Fed’s supply of credit but the economy’s demand for credit, because he made a pitiful telemarketing call to increase the demand for Fed credit.

Fed interest rate cuts push on a string.

Many of these listed effects on demand for credit are inelastic to interest rate changes (not sensitive to small changes in the price of borrowing) or completely independent of interest rate changes (downpayment requirements), so small interest rate cuts are as ineffective as pushing on a string at stopping the seismic processes underway, despite psychological Wall Street rallies.

While everything has a selling price (ING bought Barings Bank for 1 British Pound (<$2) in 1995), and non-buyers will become buyers at a certain price, the genie is out of the bottle in so many regards that small cuts might have little lasting positive effect, yet large cuts could be disastrous in so many other ways.

Next: 10 Reasons Against Federal Reserve Rate Cut


lineup32 said...

interesting site
will be visiting to increase my knowledge. Thanks for your insights.


J at IHB and HFF said...

Ron, thank you and welcome.