Last summer, when US capital markets began to freeze up, total market capitalization was $19.1 trillion. US market cap at yesterday’s close was $13.3 trillion, a drop of $5.8 trillion over 14 months, roughly $100B billion per week.
In previous articles I have likened this capital market freeze to a blackout, much like the failure of an electricity grid following a major storm. In a blackout, the electricity network fails to transmit electricity to the end users. In a capital market blackout, asset prices no longer transmit information about risk and return to end users–the investors. Investors no longer trust their ability to see the cash flow they will receive in future periods so they are not able to set values on securities. Market activity freezes up.
Until today, this massive loss of net worth has not caused a drop in GDP. That’s why I have repeatedly stressed that this is not a textbook recession, in which a drop in spending on goods and services leads to inventory buildups production cutbacks and ultimately job losses and declining GDP. This is a capital market problem, not a GDP problem.
That changed in March with the Bear Stearns crisis. The heroic measures of the Fed then to provide liquidity for troubled financial institutions have made a significant change in monetary policy. Starting with Bear Stearns, each time we faced a new crisis the Fed has made new loans available to a growing list of financial institutions. But each time they also sterilized the resulting reserve increases by selling Treasury bills from their portfolio in order to keep total reserves from growing in order to prevent potentially inflationary (their worry, not mine) increases in reserves. As a result, as late as 2 weeks ago reserves had increased at less that 2% in the previous year.
If total reserves are not growing and is large amounts of reserves are now held by institutions that previously did not hold reserves (the sick banks and major investment banks) it must follow that reserves at other banks–the healthy banks that were holding them before–have fallen by a like amount. That’s why I have likened Fed policy since March as squeezing on a balloon to push money from healthy banks to sick ones.
I believe the Fed fixation on inflation risk has been entirely misplaced. They have confused a relative price change–global oil and commodity prices–with an inflation caused by increased money supply, their proper concern. As a result they have made the property deflation much worse.
This policy has finally produced the recession that did not have to happen. Formerly healthy banks have now begun to restrict credit to formerly healthy business borrowers. That restricts working capital for small private companies–the ones that produce all the new jobs in America. Today’s employment report–down 159,000 jobs–along with a slew of other recent reports–shows the result. Falling employment, falling incomes, falling spending and falling GDP.
Some of my friends disagree with me on these points. They prefer to judge monetary policy in terms of Fed funds rates. But Fed funds rates only reveal actual conditions in the capital markets when the Fed funds market is in textbook market-clearing equilibrium where all relevant information is transmitted in the price (Fed funds rate) and there is no non-price rationing as there is today. You may remember that the Fed steadily reduced the (irrelevant) Fed funds rate during 2001-2002 at the same time the credit markets were slipping into non-price rationing, with an effective cost of capital (the rate borrowers would be willing to pay if they could get the loans at all) significantly higher than the quoted funds rate.
Today, in Washington, the gang that couldn’t shoot straight passed a massive rescue package that President Bush will surely sign. Although there are lots of things about it that I don’t like, it is at least targeted at the cause of the problem–the frozen capital markets. Unfortunately, we know almost nothing about how it will work because it gives virtually unlimited discretion to one man–the Secretary of the Treasury. I can understand the cool reception it got in the stock market. We don’t even know who the Secretary of the Treasury will be in 4 months much less what he will decide to do.
Rather than carp on the plan, I want to raise the next question we will face. If the plan is to work, and unfreeze capital markets, it is imperative that the Fed follow the right policy to support the new RTC-like measures. Last time we created a superbuyer–the Resolution Trust Corp set up to fix the S&L mess–the Fed followed the wrong policy by failing to generate the demand necessary to buy the auctioned assets without deflating their prices. As a result, land prices fell for 4 years in a row during the RTC years. We can’t afford this to happen again.
Creating a giant auction house is going to put downward pressure on security prices. It is up to the Fed to abandon their destructive sterilization policy in order to increase bank reserves sufficiently to create the demand to buy the loans without further erosion. That will require growth of bank reserves and the monetary base of 5-10% per year for some time to come. Let’s hope they figure this out soon.