The analysis by Floyd Norris in the New York Times is so wrongheaded it is difficult to know where to begin. I could complain about his focus only on banks rather than the shadow banking system, or his conflation of liquidity and solvency threats, or his comparing apples and oranges in measurements of leverage across countries. But the most important error is his claim that the US, by virtue of issuing the world’s reserve currency, has unlimited resources to throw at its financial system:
As the banking system quaked this week in many countries, and various governments took steps to bail out their banks or at least guarantee deposits, one question was asked quietly: Can the governments afford it?
That is not a question for the United States, which can print dollars and has a banking system that is the largest in the world but is small in relation to the national economy.
The last part of that sentence is about the confusion between banks and financial intermediaries (how could a Times columnist make this mistake after all that has happened during the past year?), but it is the first half I want to discuss.
Something like a trillion dollars (give or most likely take a couple of hundred billion) has been spent thus far in the pursuit of a bailout. How is it being financed? Not with money creation. The Fed can, if it wishes, treat its purchase of troubled assets (and institutions) like ordinary open market operations, simply crediting the accounts of sellers held as Fed liabilities. Indeed, it has done some of that in recent weeks, as the following chart shows.
M1 and M2 growth, 3rd quarter 2008 (index, July 7 = 1.00)
Indeed, an expansion of over 10% in M1 within the space of two weeks might be considered extravagant, except that during this same period M2 was up only about a tenth of that. In other words, the Fed is largely offsetting the contractive effects of the credit crunch, slightly erring on the side of greater liquidity. In absolute terms, the Fed’s additional injection comes to about $150B. The remainder of its bailout finance comes from a variety of sources, but essential is the global demand for treasuries, which has jumped by over $2T on an annualized basis in the first two quarters of this year compared to pre-crisis levels. It is difficult to disentangle the official from the private flows, but the latter by all accounts has been dramatic, as the herd rushes to “quality”.
The constraint faced by the Fed is the willingness of wealth holders to continue to skew their portfolios so strongly toward dollars. In an earlier post (“reverse tsunami”), I simplified by assuming that rebalancing will occur only after the crisis is over. Actually, it is entirely possible that this rebalancing (aka “capital flight”) could occur at any time. If it happens it will be triggered by a change in perceptions, that the dollar is not the rock in a raging sea that it previously seemed to be. Some of the factors that could cause this are beyond the control of Bernanke’s crew (such as one or more high profile nonfinancial defaults), but the perception that the US intends to inflate its way out of the crisis would have a similar effect and is clearly related to the “print dollars” option that Norris takes for granted. In other words, open market-style purchases of bad assets is effectively limited by private sector credit contraction. The bad assets are a stock (size unknown) and the contraction a flow, hence no match can be assumed.
A closing word of paranoia: it is difficult to overstate the significance of the financing constraint on bailout strategies. The lesson here is not 1929, but 1931-32, when a series of national currency runs whiplashed the global system and prevented any individual country from taking effective action. A change in sentiment on the dollar, if it occurs, will be sudden, unexpected and massive. An outflow of funds would stop the Fed/Treasury strategy in its tracks and mark the end of any meaningful program to restore financial markets. No one knows what the tipping point could be, or even whether the most enlightened policy can avert it. (In that respect our financial imbroglio resembles the risk of catastrophic climate change.) But its shadow looms over the entire operation, and this is constraint that policy-makers should keep firmly in mind, assuming they are not as clueless about the existential risks we face as current journalistic coverage.
