Thursday, August 23, 2007

Sound Policy or Liquidity Addicts?

What is the appropriate role of the Federal Reserve at this time? Most views on this question fall into one of three camps: (1) the 'inject much more liquidity now' view, (2) the 'inject some liquidy now to prevent contagion' view, (3) and the 'exercise monetary restraint now' view. What to make of these competing views? I want to focus in this posting on the 'inject more liquidity now' view. This group represents the Jim Cramers of the world who never tire of calling for more monetary easing whenver a finanical storm besets the markets. Below is an Op-Ed piece I wrote that addresses this very group.

Sound Policy or Liquidity Addicts?

"Ben Bernanke needs to open the discount window…He is being an academic! This is no time to be an academic. Open the darn discount window! ...My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he's nuts! They're nuts! They know nothing! . . . The Fed is asleep…"
Jim Cramer on CNBC, August 3, 2007

Jim Cramer could not be happier. The Federal Reserve surprise discount rate cut of 50 basis points this past Friday spurred a brief recovery in markets and has created expectations of a Federal Funds rate cut in the September FOMC meeting. Jim Cramer and others like him who had been calling for an easing of monetary policy by the Federal Reserve surely feel vindicated by the market’s response on Friday and now are even more emboldened in their call for further interest rate cuts. But does this policy response make sense? Are these champions of interest rate cutting promoting sound policies that address the underlying problems or are they liquidity addicts simply begging for another shot of liquidity to get them through the hangover of the last monetary easing binge?

There are several compelling reasons to believe that these calls for the easing of monetary conditions are in fact nothing more than the cries of liquidity addicts hoping to avoid the needed correction in financial markets. First, the Jim Cramers of the world fail to recognize the difference between a liquidity crisis and an insolvency crisis. A liquidity crisis is when an individual, firm, or some sector of the economy is solvent but temporarily short of liquidity. For example, if an individual is unexpectedly hit with major medical expenses that he cannot pay out of pocket, but could pay once he sells some of his assets, such as land, then this individual is facing a liquidity crisis. However, if this same individual cannot pay out of pocket and has no assets to draw on then he is insolvent and facing an insolvency crisis. In the former case, extending credit or liquidity to this individual makes sense since he has assets to cover the new line of credit, but in the latter case extending credit would only postpone and maybe worsen the insolvency. This distinction is important because as Nouriel Roubini has shown the current turmoil in global markets is the result of an insolvency crisis not a liquidity crisis. Roubini notes in particular that this crisis stems from insolvencies and bankruptcies in mortgage-ladened households, mortgage lenders, home builders, and some hedge funds all of whom were driven by real economic distortions in the housing sector. These excesses in the housing sector simply cannot be waved away by some magical liquidity wand. This current insolvency crisis stands in stark contrast to a true liquidity crisis that emerged with the Long-Term Capital Management hedge fund debacle in 1998. Then, the Federal Reserve was able to successfully intervene and thwart a credit crunch, but it occurred in the context of a robust economy with no signs of broad insolvency. Believing that more monetary accommodation now will save the day misses this important distinction.

The Jim Cramers of the world also seem to forget what got us here in the first place: past monetary excesses. Following the recession of 2001 and the deflation scare of 2003, the Federal Reserve lowered it policy interest rates from a high of 6.5% in early 2001 to a low of 1% that was maintained through the summer of 2004. Although monetary policy began tightening in the second half of 2004, the federal funds rate was still lower than the year-on-year growth rate of nominal GDP through 2006. By keeping the interest rate below the growth rate of the economy for so long, there was every incentive for excessive leverage. Moreover, the lowering of interest rates in response to the deflation scare of 2003 looks to be particularly distortionary in retrospect. Rapid productivity gains appear to have been the source of the low inflation in 2003, but rapid productivity gains imply a higher policy interest rate, not a lower one, is needed for monetary policy to stabilize economic activity. It is no coincidence that these policy moves coincided with the housing boom and the related distortions in mortgage markets that are only now beginning to be worked out. The irony in all of this is that the Jim Cramers of the world are now calling for more of the same liquidity medicine that generated the financial imbalances in the first place—a surge sign of liquidity addiction.

Finally, the Jim Cramers of the world fail to grasp the implications of their policy prescriptions going forward. As has been discussed already on these pages, every time the Federal Reserve steps in to calm financial markets it creates less incentive for investors to be more careful next time. To the extent the Federal Reserve is setting a precedent in the mind of investors and creating moral hazard, it is perpetuating a culture of liquidity addiction. If the Federal Reserve continues to follow down this path of accommodating the markets, then we have not seen the last Jim Cramer rant against the Federal Reserve nor the last of the liquidity addicts. Another implication going forward of this policy prescription for more monetary easing is that it may put downward pressure on the dollar. To the extent the dollar has been overvalued this may be a good outcome, but ongoing interest rates cuts in the midst of market turmoil and could lead to an outright run on the dollar. Either the Jim Cramers of the world simply cannot see far foward enough to appreciate these dangers or they personally high discount rates.

The Jim Cramers of the world then are liquidity addicts who are prescribing the U.S. economy go on another Fed Spirits binge and put off the financial hangover until another day. The U.S. economy has been down this road before after the last asset bubble burst in the early 2000s. Here is hoping the Federal Reserve does not follow their policy recommendations, but allows the U.S. economy to finally sober up.


  1. Professor,

    Insolvency crisis? Dr. Roubini has been predicting a global crash, hard landing scenario since 2004. His recent liquidity crisis vs. insolvency crisis posting provided no supporting facts that major financial institutions are approaching insolvency. How does he know this? Of all the lent money in the world, how much of it will default? And will this number be significant? His answer to this last question would probably be an emphatic yes, but he has boldly predicted a variety of crises in the past three years.

  2. Anonymous,

    thank you for the comment. You are right, Nouriel Roubini has been calling for some form of correction since 2004 and has been called by some a doomsdayer. However, before you dismiss him altogether consider these brief points:

    (1) All of his predictions have been based on solid economic analysis. For example, his concern that U.S. may be headed for a hard landing because it has been persistently running large current account deficits is not unreasonable based on both theory and past experience. One can dispute his conclusions, but his methods are not in question.

    (2) 2004 is not that long ago. Sometimes economic distortions take awhile to become manifest. Given we are talking about a global economy with lots of frictions, we should not be surprised at economic imbalances taking several years to get worked out. The collapse of the Bretton Woods system took place in the early 1970s, but the distortions were occuring many year before then.

    (3) Maybe what we are seeing is fulfillment in part of Nouriel Roubini's prediction. Roubini's focus has mostly been on the global economic imbalances, but maybe what we are seeing is some of the unwinding (and the related collateral damage) of these imblances.

    (4) We do not yet know the extent of the losses from the subprime and other mortgage related losses. Nouriel suggest it could be as much as $500 billion which would be just under 4% of GDP, a non-trivial amount.

    (5) Finally, I think the insolvency crisis is correct since we are talking about real economic distortions in the housing sector that have to be worked out (e.g. millions of foreclosures & excess housing supply), as well as a credit crunch that is still causing problems (See Nouriel's latest posting:

    These brief points may not convince you, but I think Nouriel Roubini has a least earned the right to be taken seriously.

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