The US Federal Reserve loves the credit bubble

The US Federal Reserve loves the credit bubble
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First Published: Fri, Jan 25 2008. 10 59 PM IST
Updated: Fri, Jan 25 2008. 10 59 PM IST
Is the US market poised for a sell-off? Not to worry, Ben Bernanke will reduce interest rates. Have US banks started to distrust each other? Not an issue, they can always borrow from the US Fed. Is a mortgage company on the brink of bankruptcy? Don’t worry, the Bank of England will nationalize it.
Could the US face a recession? Relax, the government is going to let the fiscal deficit go through the roof. Are bond insurers in danger of getting de-rated? No problem, the insurance regulator will ensure that banks put up money to bail them out. Are the markets not satisfied with the biggest rate cut in the last 25 years? Take it easy, Uncle Bernanke will give you some more.
The chairman of the US Federal Reserve is a student of the Great Depression of the 1930s, and he believes that one of the reasons it happened was because the Fed was too slow to cut interest rates. He once said that deflation could always be fought by dropping money from helicopters, if necessary, a remark that earned him the nickname “Helicopter Ben”. He now has a golden opportunity to put his beliefs to the test.
Will it work? It might. After all, rate cuts by Alan Greenspan laid the basis of the boom in the global economy from 2003-07, although the US wasn’t able to escape a recession. If we have a repeat of the same scenario, the US will go into recession for a year and global markets will recover in two years. But this time the rate cuts have been pre-emptive and deeper.
In 2000, after the tech bubble burst in the early part of the year, it wasn’t until January 2001 that the Fed started cutting rates. It was only in August 2001 that the Fed funds rate went down to 3.5%. In contrast, Bernanke has already cut rates to 3.5%. His being quick on the draw may pay off.
On the other hand, there’s no guarantee that it will.
Japanese example
Parallels are sometimes drawn with Japan in the early 1990s. After the Plaza Accord that revalued the yen against the dollar, the Japanese authorities, faced with lower exports, decided to stimulate the economy. Money supply shot through the roof, the Nikkei soared and land prices went to stratospheric levels. The central bank then raised interest rates to curb the absurd asset prices, which ended up bursting the bubble.
After that, despite a series of rate cuts and in spite of flooding the markets with money and driving interest rates to near zero, the Japanese market is nowhere near the peak it reached during that time, while the economy remains mired in stagnation.
Even if we don’t buy the Japanese example, it’s quite possible that rate cuts may not solve the problem. Even if the banks are recapitalized, the exotic derivatives market may be frozen for some time.
In the meantime, all sorts of frauds that were kept under wraps during the boom times will come to light, as they already have at Societe Generale SA.
Litigation will grow, as investors who were sold dud financial products sue for their rights. Banks may find it difficult to sell their collateral, because the law is unclear about the rights to securitized assets. Risk-taking will be subdued for some time and the banks may curtail their proclivity to create liquidity out of thin air. Perhaps this kind of a soft-landing is what Bernanke is aiming at.
Real dangers
On the other hand, there are also some very real dangers. For starters, markets and banks could now believe, not without justification, that Uncle Ben will always be there to bail them out. Banks may have little incentive to improve their lending practices and their fondness for mis-selling little-understood arcane financial derivatives to greedy investors could continue. The stage will have been set for the creation of another asset bubble as a result of a new wave of liquidity being unleashed. It was, after all, excess liquidity that created the problem in the first place—the bubble will only become bigger and when it bursts, it will do far more harm.
But maybe Bernanke is right. The credit bubble has become so vast that pricking it may lead to a huge depression.
Consumer credit is the lifeblood of economies today, allowing people to have tomorrow’s income today. US consumption buoys the world economy and it allows firms to increase sales and profits. Innovations like securitization have allowed banks to lend even more, because selling down loans frees up their capital for more lending. Derivatives increase leverage many times, allowing banks and speculators to create assets out of thin air.
For example, derivatives expert Satyajit Das makes the point that when General Motors Corp.’s debt was downgraded to junk status, it was found that the amount of credit default swaps on the debt was four times the value of the debt. That was then—with all kinds of exotic products such as CDO (collateralized debt obligations) squared and CDO cubed, the value of the financial assets created will now be many times the worth of the underlying real assets.
If this huge inverted pyramid collapses, it could bring down the entire economy with it. Perhaps the US economy has the bubble as its foundation.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at
capitalaccount@livemint.com
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First Published: Fri, Jan 25 2008. 10 59 PM IST