2008 March 18 Tuesday
Will Federal Reserve Tame The Financial Panic?

Are you all aware of how monumental the recent events in financial markets have become? MIT economist Paul Krugman thinks the total losses in housing might range between $6 trillion and $7 trillion. That's equal to about half a year's GDP of the United States.

Fortune: By year-end, 15 million Americans could have mortgages worth more than the value of their homes. What happens then?

Krugman: Actually, I think home prices will fall enough for us to produce about 20 million people with negative equity. That's almost a quarter of U.S. homes. If home prices are rising, or if there's positive equity, you can refinance or sell. But if you have negative equity, you can end up being foreclosed on, and then some people will just find it to their advantage to walk away. We're probably heading for $6 trillion or $7 trillion in capital losses in housing. Some fraction of that will fall on owners of mortgages. I still think the estimates people are putting out there - $400 billion or $500 billion in losses - are too low. I think there'll be $1 trillion of losses on mortgage-backed securities showing up somewhere.

Such a large drop in housing prices will, if it comes to pass, cause an extended recession as people spend less in response to feeling poorer. I think the Fed is ill placed to prevent it without causing general price inflation. Currently the Fed is putting prevention of financial panic ahead of stopping inflation. But I do not think prevention of financial panic alone will stop a big drop in housing prices.

Alan Greenspan says our current economic crisis is going to be the worst one since the Great Depression. (and notice how he used WWII rather than the obvious Great Depression as the time end-point)

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes – those belonging to builders and investors – have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will stabilise remains problematic.

Nouriel Roubini says conventional Federal Reserve monetary policy has become useless to stop the panic.

Since the onset of the liquidity and credit crunch last summer this column has been arguing that monetary policy would be impotent to address such a crunch because, in part, of the existence of a non-bank “shadow financial system”. This system is composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and other non bank financial institutions.

The Fed has responded by becoming a massive lender and even to non-bank financial institutions.

The response of the Fed to this run has been radical and in the form of the extension of the lender of last resort support to non bank financial institutions. Specifically, the new $200 bn term facility allows primary dealers – many of which are non banks – to swap their toxic mortgage backed securities for US Treasuries; second, the Fed provided emergency support to Bear Stearns and following the purchase of Bear Stearns by JPMorgan, is now providing a $30 bn plus support to JPMorgan to help the rescue of Bear Stearns; finally, now the Fed is allowing primary dealers to access the Fed discount window at the same terms as banks.

Yet long term interest rates are going up and the Fed is fighting against a market that fears it will generate inflation on top of the commodity-driven inflation.

Gotta say the Fed decided to set new precedents and made radical departures from past practices without first waiting for a new economic depression to break out. The big $200 billion Fed loan to security dealers in exchange for dubious financial instruments amounts to an attempt by the Fed to counter the credit tightening effects of a flight to quality. Ben Bernanke is a student of the Great Depression and doesn't want another one on his watch.

These bold departures from past practice have not ended the fear in high finance. The "TED Spread" is still too large as of this writing. TED spread stands for Treasury Euro Dollar interbank loan interest rate difference or spread. The bigger that spread the more fear that banks have about loaning to other banks.

In his excellent essay "The $1.4 Trillion Question" in The Atlantic James Fallows explores the massive trade deficit of the United States and the massive trade surplus of China and says this imbalance has to end somehow and it might end in a panic.

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China. Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere.

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

I see one big problem looming on the horizon that might outweigh all this financial engineering: Peak Oil. The US Federal Reserve and its equivalents in Canada, Britain, and the Euro zone can't financially engineer their way around declining supplies of energy.

Update: If we are facing only a liquidity problem then the Fed can handle it. But if we are facing an insolvency problem (i.e. lots of asset holders have greater liabilities than they have market value in their assets) then the Fed can't stop what is happening. The Fed can try to inflate away debts by expanding the money supply. But either the Fed causes a huge inflation or lots of financial firms and other firms go under. Some analysts think we are near a liquidity trap. But if insolvency is our real problem then the fear of a liquidity trap is, strangely enough, an optimistic interpretation.

Share |      By Randall Parker at 2008 March 18 10:22 PM  Economics Business Cycle


Comments
Kenelm Digby said at March 19, 2008 4:17 AM:

Two comments:
Very few people alive today have any memory of the 1930s depression - to most people it is a 'mythological' rather than an 'actual' event.
When the IMF deals with collapsed economies and collapsed currencies, its prognosis is usually the polar opposite of the Fed's.Usually it demands that the nation hikes up interest rates, slashes public spending all in the name of 'sound money' - which is supposed to be the post Keynesian 'neo-liberal' orthodoxy, I wonder if this lesson has been lost on the countries forced to undergo this hardship recently at American behest?
Likewise, some elementary arithmetic tells us that since America generates absolutely no savings whatsoever, all of the money thrown at the markets must ultimately originate from the far East.This fact cannot square-up with a falling dollar and slashed interest rates - hyper inflation is the only logical result.

Wolf-Dog said at March 19, 2008 4:38 AM:

"I see one big problem looming on the horizon that might outweigh all this financial engineering: Peak Oil. The US Federal Reserve and its equivalents in Canada, Britain, and the Euro zone can't financially engineer their way around declining supplies of energy."
-----------------------------------------------------------------------------
The Federal Reserve cannot engineer our salvation from oil addiction, but the government can: 50 % of the money that is allocated to the budget of the military industrial complex, can be given to alternative energy and battery R & D (at leat $250 billion per year), and this would solve the problem within less than 5 years.

The advanced batteries are very close to being practical for pure electric cars, and once 250 mile range is attained, the electric grid can handle electric cars with minor modifications.

http://www.evworld.com/article.cfm?storyid=1258

Bob Badour said at March 19, 2008 6:00 AM:

A bone to pick: The end of WWII is not the same endpoint as the Great Depression. Between those two endpoints, one finds a radically different wartime economy where people rationed basic goods and almost every resource, including credit, went to drive the war machine.

If Greenspan picked the end of WWII as the endpoint, he is saying the disruptions of WWII were bigger than the current crisis. Let's hope he is right.

Snouck said at March 19, 2008 7:54 AM:

The Fed is creating vast amounts of money to try to stem the monetary crisis. Inflation seems to be very low if one takes into account money creation.

Are the statistics being doctored?

And why did the FED stop publishing M3? http://www.federalreserve.gov/releases/h6/discm3.htm

Regards,

Snouck

Ned said at March 19, 2008 8:22 AM:

My 96 year old father in law remembers the Great Depression very well. He talks about it like it just ended. And although he fought in the Battle of the Bulge, I think he considers the Great Depression a worse experience. He is still very tight with a dollar, although he has plenty of them now.

m said at March 19, 2008 9:50 AM:

Peak oil?


We have 500 years worth of oil in Coal, which can be converted into gasoline, at present rates of consumption (about five bucks a gallon)

We have more shale oil in the West than Saudi Arabai has oil period (about six bucks a gallon to get at)

Canada has about equal the amount of oil in sand that Saudi Arabia has oil (about six bucks a gallon to get at)

We can also use cars like Chevy's Volt (2010) that will get 40 miles on the battery at full recharge before burning fuel. Nuclear and other forms of energy could produce the extra plug-in electricity for this

We have all the oil off our continental shelf that we can drill, we just need to drill it

We have all the ANWR oil


We can always use ethanol in a hybrid (Chevy VOLT) car that reduces its usage. The GOOD thing about ethanol is that it IS inexaustable. Every year you grow sugar cane and corn and wheat is every year you literally make more of it from nothing. It GROWS out of the ground.


We really do need to get on the nuclear plants. Uranium is plentiful and is clean. We at least need to be putting solar roofs on houses and small wind turbines on every damned telephone poll in this nation to take advantage of any "gimme" energy that we can get our paws on. We would also do well to look into the oceans waves as sources of energy and especially geothermal (the biggest potential source of energy on the planet).


Believe me, we will have oil for the next 50 years....................but we sure as hell do need to be looking for something like NOW to replace it. We dont need to wait until we are starting to have less of it. When we elect two oilmen as president however, you aren't going to get much forward thinking on the issue from people who'd rather put their heads in the ground and dream that it will flow forever. We will still have modern civiliation goddammit post-oil, we are not animals like James Kunstler believes, but we have to plan for it intelligently by using our minds in rational way.

Mark Amerman said at March 19, 2008 10:19 AM:

Well the answer is that -- of course -- the government will engineer general price inflation.
I don't know how much weight to put on what Paul Krugman says. My impression is that
he's not really a serious economist anymore, but assuming that there's anything like this
danger, the fed would be insane not to print money wildly, which comparatively is a relatively
easy out.

In any case that's more or less exactly what the government is doing right now and has been
doing for some time.

Mark Amerman said at March 19, 2008 10:28 AM:

Kenelm Digby,

Yes, there's quite a contrast between our behavior and what the IMF has
urged other countries to do when then get in these sorts of binds.

But in all fairness to the U.S. government, I think it needs to be
pointed out that -- even assuming it really is a good idea -- exactly
how does one slash spending when China and Japan and others are pouring
in billions of dollars into the U.S. economy a day in an effort to keep
the U.S. dollar artificially high and have been, not so incidently, doing
so for many years before this crisis?

Jump said at March 19, 2008 2:20 PM:

I addressed "Peak Oil" mythology in a previous thread. For those of you who don't buy into the scam, look up the Bakken Oil Formation out in the Dakotas (estimated at 200-500 billion barrels of oil, discovered in 1951). See also Gull Island, and the tiny amount of land drilled and explored in the Strategic Petroleum Reserve in Alaska, much less ANWR. See also the 36 billion barrels estimate of heavy oil in Alaska that is bigger than the Prudhoe and Kuparak oil fields combined. Also, as M says, huge reserves just off the coast of America in CA, FLA, and the east coast. "Peak Oil" scam = engineered shortage = price gouging on a gigantic scale.

Randall Parker said at March 19, 2008 5:56 PM:

Wolf-Dog,

I agree that most of the money we spend on the military would be better spent on energy research and conservation measures.

m,

Last year a National Academy of Sciences report slashed US coal reserves by 60% They estimate then at current consumption rates we have 100 years left. Even before that big slashing the multi-century projection for coal reserves was based on current consumption rates. Well, as oil production drops what will happen to coal production?

A group of German researchers known as the Energy Watch Group puts world Peak Coal possibly as soon as 15 years. The pattern in recent years has been big revisions downward of remaining reserves by several countries. The Energy Watch Group says that if we look at energy content of coal rather than tons of coal then US coal production already peaked in 2002.

David Rutledge at CalTech applied Hubbert linearization to all fossil fuels consumption and came up with a similarly pessimistic prediction about future coal production.

Wolf-Dog said at March 19, 2008 9:16 PM:

"Last year a National Academy of Sciences report slashed US coal reserves by 60% They estimate then at current consumption rates we have 100 years left. Even before that big slashing the multi-century projection for coal reserves was based on current consumption rates. Well, as oil production drops what will happen to coal production?
A group of German researchers known as the Energy Watch Group puts world Peak Coal possibly as soon as 15 years. "
--------------------------------------------------------------------

If this is true, it probably also means that we must concentrate on cellulosic ethanol production, but if we cannot burn more fossil fuel to generate more CO_2, then perhaps the amount of carbon in our planet may not be sufficient to sustain long term cellulosic ethanol production even if this is a closed circuit system, since trees and wild grass, etc, need carbon dioxide to grow, just like all agricultural products. This might be precisely why very soon we might need nuclear energy. There is plenty of uranium in the world.

Jump said at March 19, 2008 9:24 PM:

Peak Anything is a scam. I can't for the life of me understand why you perpetuate this false baloney. Its obvious that Peak Oil propagandists are paid off shills and liars.

A great example is Kenneth Deffeyes of Princeton, who lied about oil formation and said that you can't find oil at depths much beyond 7500 ft. Then the Jack well in the Gulf of Mexico gets trumpeted, which is 28,000 feet below the ocean floor. What joke these guys are! Richard Heinberg teaches at a store front "college" in San Francisco, where he got his college degree in--get this--"leadership". Hahaha! He also put out a piece called "50 Million Farmers", where he lauds the good ol' communist farming model of Cuba! Wow. How do guys in Germany know how much coal is in Ohio or Illinois? Answer--they don't. They are fake paid-off shills like Defffeyes and Heinberg, and Matt Simmons as well.

I live right in the middle of coal country--Illinois. The state is practically made of the stuff. I've got relatives that work in the coal industry. You can see old coal mine heads everywhere here. There is sooo much undiscovered coal here its ridiculous. I wouldn't believe anything put out that there is any kind of shortage of carbon based fuels at all Certainly not coal. On what basis was the reserve estimate reduced? Is it like all the big Alaskan, Wyoming, North Dakota, and Texas oil finds that are capped and never spoken of, like the ones I listed above?

https://engineering.purdue.edu/Engr/Research/Focus/2006/CoalFever

http://www.planetark.com/dailynewsstory.cfm/newsid/34152/story.htm

http://www.teachcoal.org/aboutcoal/articles/coalppf.html

There's one big problem with calculating coal reserves--only a small fraction of the reserves have been delineated. Many mine sites are placed OFF LIMITS by farmers' groups that oppose mining (guess who funds these guys?) and the fact that about 60-80% of all the coal out west is under the control of the federal govt. (which means its under the control of the big oil companies). Coal is simply so abundant that only a fraction of it has been discovered here, and around the world, and that's the real truth. If you think those paid off German nitwits have any real idea of how much coal there is, you're simply naive and know little about the industry. You act as if all the information to make the stupid proclamation of "Peak Coal" is available. Its like saying we know how much limestone there is in the United States. Its totally ridiculous.

See, the big oil companies are buying up all the coal companies with your high oil prices. Then paying off lying academic goofs to tell you "there just ain't enough to go around-hahahahaha!". You'd think people would be smarter than that.

The big energy companies are trying to create artificial scarcity of carbon fuels, along with their "global warming" baloney, to institute total control over your life, gigantic global carbon taxes, environmental inspectors invading your home to levy taxes and fines, etc. The whole false premise is that CO2 is some kind of poison that will kill us all. In actual fact, more CO2 is great for life, as plants flourish, the animals that feed on plant life flourish, and the carnivores that feed on plant eating life flourish. Its a big win for everybody.

Only 3% of the CO2 released every year comes from human activity. Almost all CO2 comes from the ocean. And CO2 is a very minor greenhouse gas compared to water vapor, which has even less effect than concentrated water vapor (i.e. clouds!). Its nonsense that CO2 levels have anything to do with global temperatures at all. In fact, CO2 is a LAGGING indicator of temperature, as warmer water releases more CO2 than cold water, which acts as a CO2 sink. But it doesn't matter, as CO2 is harmless anyway.

Global warming and cooling are created by the sun cycles and fluctuations of solar output. Even minor fluctuations in the sun's output can cause 5-10F changes in average temperature either way from a mean temperature. You are being suckered. "Peak" carbon fules and "global warming" are lies. You can invest and make money as if they were true, because we are all falling under a corporate dicatatorship here and abroad, but the truth is that it is all engineered to suck us dry.

Robert Hume said at March 20, 2008 7:22 AM:

Hubbert predicted peak oil in the US for 1970. That's what happened. It's still true. Why should predictions for the world using similar techniques be false this time? We're talking peak oil, not peak oil shale. Oil shale is much more expensive so our standard of living can't be the same as if we still had available plenty of oil. Nuclear is certainly the way. We have to carefully address the terrorism problem, of course.

deepak said at March 21, 2008 7:34 PM:

Again, many oil finds in America have been capped. It doesn't matter if oil production "peaked" in 1971--that was engineered, not a result of any true scarcity. Its still the case today.

The real reason that oil production in the US was capped in 1971 is that internationally, the US dollar went off the gold standard. The dollar was then backed by another commodity--oil, which there was far more of.

Because of the excess dollar creation needed for the Vietnam War and the Welfare State, the leaders of the US hit upon a grand plan--to avoid the massive price inflation due to this money printing in the US, we would "export" these excess dollars to oil producing countries. Thus the "petrodollar" was born. Oil producing countries would be the first to dump a non-gold backed dollar. So we "peaked" our production and started importing oil, in order to export our dollars! The oil producing countries accepted our treasury debt for payment, instead of gold, because we have lots of guns. This method of exporting inflation has been true ever since then. Our gigantic trade deficits now are just an extension of a 35 year old policy.

Oil prices are rigged in by oil producers and central banks in order to export our dollars. If we produced all of our own oil and manufactured goods at home, we wouldn't be able to export the inflation and the politicians and central bankers wouldn't have been able to spend and tax like they have for the last 35 years. The tremendous monetary inflation has made many insders very very rich for a very long time. It even created the illusion that the rest of us were rich. Soon, that illusion will evaporate.

Unfortunately for us, there are new currencies around that will compete with ours and the dollar is now being dumped. The game of exporting our excesses to other countries is at an end. we will see all those dollars come back to the US and we will experience a Wiemar hyperinflation.

"Peak OIl" is the same type of scam, but with a twist-- a resource shortage will be engineered, not to export inflation to other countries, but to create a one world government that will suck us dry through carbon taxes and environmental fines. You can think of it as the central banks and corporations, united in a form of world fascism, exporting their monetary inflation to us while we export our labor to them. High commodity prices guarantee that we will all be too poor to rebel or resist this takeover.

Hence the "global solutions" needed for "Peak Oil" and "global warming". Get ready for the chains.

Bob Badour said at March 21, 2008 8:08 PM:

Deepak,

Some of your reasoning is unsound. Peak Oil obviates any need for carbon taxes or environmental fines. Once we don't have oil and coal to burn, we cannot add any more carbon to the atmosphere.

mike said at March 23, 2008 3:02 PM:

The 1930s depression was in some ways a sign of economic strength, it indicated there was too much production and not enough consumption, hence the introduction of Keynesian 'carpe diem' policies.

Today, we have the opposite problem, too little production and an economy geared towards pampering every whim of the consumer. This problem is much harder to solve, it's one thing trying to persuade people to 'live a little' and another to convince them to bite the bullet and make long term sacrifices for the future. And the stakes are high, those western countries which don't make changes won't be in the first world much longer.

Engineer-Poet said at March 23, 2008 8:52 PM:

I offered Jump a bet that his claims were wrong.  He railed at me, but (tellingly) he refused to take the bet.  In other words, Jump doesn't believe what he says.

Deepak, do you really think that the US is holding back on oil production?  How much do you want to bet?

deepak said at March 24, 2008 1:47 PM:

E-P

Jump was censored from the site because he disproved the disinfo campaign of "Peak Oil" and "Peak Coal" and pointed out that there are gigantic oil and coal resources that are never reported in the manstream press. This site also ignores these stories and promotes peak fossil fuel disinfo from sources that have been proven to be liars.

If you have any information, just give it and let it be refuted. You're not holding onto any kind of precious knowledge.

Engineer-Poet said at March 24, 2008 2:32 PM:

I see comments by Jump in this thread and also this one, where he refused to answer me.  I see no censorship, just dodging the subject.

Just like you're trying to change the subject instead of answering me.  You're making claims of fact.  How much do you want to bet that they are actually correct?  I've got ten G's that says they aren't.

Randall Parker said at March 24, 2008 5:37 PM:

Deepak,

I haven't deleted any of Jump's foolish posts and I'm the only one who can do it.

For some reason the global oil conspiracy hasn't bothered to either threaten me or offer me a bribe to delete Jump's posts. Maybe this is a clever strategem on their part since maybe Jump is one of them and posts ridiculous unsubstantiated arguments in order to discredit the conspiracy theorists.

Engineer-Poet said at March 25, 2008 4:46 PM:

Nothing from Deepak in a day.  I guess he doesn't believe what he's saying either (at least, not enough to try to get my money!).

Engineer-Poet said at April 1, 2008 7:05 AM:

Make that nothing in a week.  Heck with him.


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