In this article, and others to follow under the category “Slight Departure,” I will take a slight departure from the narrow topics that dominate this blog. Instead, I will focus on broader economic issues and attempt to make sense of current macro economic conditions. Enjoy!
One Way Ticket
Yields on U.S. Treasuries have fallen quite a bit over the last 12 months across maturities. This was probably caused in part by what has been dubbed a “flight to safety.” That is, investors have sold off “risky” positions in exchange for safer ones. But why? My personal opinion is that while risk aversion is certainly playing a part in the quick movement into Treasuries, this risk aversion was itself spurred by a rush to meet short term obligations. Please note that this is my own version of what happened and what is to come. Anyone claiming to have a conclusive answer to such a broad question is either incorrect or correct as a matter of coincidence.
Mortgage backed securities, CDOs comprised of mortgage backed securities, and the like (collectively refereed to as “Structured Products”) were widely held and widely believed to be fairly liquid and safe. But, for reasons that will likely be debated for decades if not longer, they became illiquid as the markets in which they were traded fell apart. If you were holding one of these, you were stuck with it, unless you were willing to sell it for pennies on the dollar. But before the failure of these markets, those holding Structured Products continued to accumulate short term obligations based on the assumption that Structured Products could be sold, if necessary, to meet these short term obligations. That is, they continued to operate under the reasonable and shared assumption that at any point, Structured Products could be exchanged for an amount of cash close to the par value of the product. When this assumption failed, it caused those holding Structured Products to sell other liquid assets and if necessary draw on existing lines of credit to meet these short term obligations. In my opinion, this bout of collective selling and exhaustion of credit began the first wave of downward pressure on prices.
Many of the entities holding Structured Products were banks or other institutions subject to capital requirements and regulations. When the Structured Products they were holding became illiquid, devalued, and subsequently downgraded by the various ratings agencies, various capital regulations forced them to either raise equity capital or shift their asset allocation towards high rated assets. In order to do this, many such entities simply sold riskier assets and purchased low risk assets or held the cash. This collective selling put enormous downward pressure on asset prices across asset classes, with the notable exception of Treasuries, where prices soared and yields plummeted. Moreover, the most dramatic drops along the Treasury yield curve were front loaded, in short term Treasuries. This is consistent with a rush out of other asset classes and into short term treasuries. Thus, it is arguable that those entities holding Structured Products simply liquidated other assets en masse in order to meet short term obligations and comply with capital requirements.
The Supply Of Credit
As mentioned in the previous paragraph, many of the entities holding Structured Products were banks. And for banks, like any other business, resource allocation is a zero sum game. That is, if banks allocate more cash to one endeavor, they must allocate less to at least one other. This simple observation suggests that as banks allocated more cash to Treasuries they could have cut back on lending. The dramatic escalation in short term LIBOR rates that took place over the last year (which has since subsided) suggests that there was indeed a severe shortage of credit, particularly short term interbank lending. As the cost of credit increases, the total cost of assets purchased using credit increases, which lowers the price at which these purchasers are willing to purchase assets. So those who purchase assets using credit will become less competitive during a credit shortage when compared to those who pay for assets with cash. Thus, the demand for assets in general should be expected to shrink given a large enough contraction in the supply of credit. This exerts further downward pressure on asset prices across asset classes.
Joe The Plumber
A decline in asset prices across asset classes decreases the balance sheet wealth of not only institutions, but individuals as well. This could lead to a decrease in consumer spending as the perceived wealth of individuals decreases, which would exert downward pressure on non-financial asset prices. This is consistent with the recent decline in the CPI.
And in addition to the individual’s role in the so called “real economy,” the individual also plays a role in the financial system. If individuals do not believe that the assets they have in the financial system (bank deposits, mutual funds, etc.) will maintain their value, they will have an incentive to sell these assets in exchange for cash. This not only exerts downward pressure on asset prices, but it exerts upward pressure on the cost of capital, particularly for banks, since this type of behavior erodes the deposit base.
Rinse, Lather, Repeat
A decline in asset prices across asset classes could cause the capital structure of a bank and therefore its ability and willingness to lend to deteriorate. As mentioned above, it could also cause its cost of capital to increase. As a result, the entire process outlined above could begin anew as a result of it having occurred once, compounding the downward pressure on asset prices.
Tis Good To Be King
So what should we do to stop this financial recursion? I have a few ideas. Again, these are my ideas, and you should keep that in mind. These problems are maddeningly complex and gigantic in scale and so you may not agree with my ideas for any number of reasons. That said, something must be done. And despite deep reservations, I think that U.S. government spending during this crisis is the thing to do.
Right now, the U.S. Government is able to borrow at almost 0% interest at a time that the U.S. dollar is at its strongest in years against certain currencies. This is a truly odd combination, but could be explained if we accept that people are leaving capital markets all over the world and running for the hills, i.e., U.S. Treasuries and therefore U.S. dollar denominated assets. This market dynamic will change in the long run, hopefully. So, my plan to exploit this aberration would be as follows:
Flood the market with short term and medium term U.S. Treasuries and thereby borrow to the hilt. Spend this money on fixing the U.S. financial system (creating more repo facilities, buying toxic assets, etc.) and U.S. infrastructure projects (to create jobs and demand for non-financial assets). The net effect of this is to allow the private entities in the U.S. economy to borrow at near 0% interest, giving the U.S. a tremendous near term advantage over the rest of the world.
At some point, this borrowing will push the interest rates on Treasuries up and will push the dollar down. When interest rates on treasuries reach non-bargain basement levels of borrowing, the U.S. should stop borrowing. But what about the green back? As a bonus, because the U.S. dollar will eventually fall from its current heights, the U.S. debt issued until that point will depreciate in value.
Thus, the U.S. could borrow for almost no interest, pump that money into its own economy, and then get a free principle reduction at the end. As for the rest of the world, yes, my solution rests your fate on the shoulders of the U.S. economy. I’m sorry, but I just don’t have enough time to think of a way out of your mess as well.