7 Fixes for a Market Failure
They have blown up the trust on which business depends. In the financial world, once you have to prove you are worthy of credit, it's virtually gone. Creditors no longer trust borrowers, but if creditors don't roll over their short-term loans, the borrowing businesses will collapse. The problem is that the Federal Reserve's role as the lender of last resort is limited to commercial banks and doesn't cover other entities involved in banklike activities. And in this shadow world that has evaded regulation created during the 20th century, we just don't know who owes what to whom or whom to bail out.
The result is a contagion of credit exposure and a massive hoarding of liquidity as banks restrict credit to each other and to nonbank financial institutions, threatening a downward spiral. Banks are not lending because the mood is one of fear and uncertainty, aggravated by bad loans accumulating faster than the amounts the banks have reserved for the contingency. For the first time since 1993, the value of loans past due exceeds the reserves for bad debt.
Normally, the economy goes bad first, and that leads to financial problems. This time it is financial problems that are dragging down the economy. Defaults are increasing in other areas of unsecured consumer debt—credit cards, auto loans, and student loans. The risk of corporate defaults is rising from minuscule levels, under 1 percent, but in a typical recession, default rates can rise to many times that.
The risk is of a chain reaction. People rush for safety, pushing stocks and bonds lower, further weakening financial institutions by devaluating their assets, as banks pull back on their capital at risk. That, in turn, intensifies the credit crunch and aggravates the economic downturn.
The financial system is substantially frozen. It cannot channel funds from savers to those who need to borrow money. Businesses are struggling for access to funds, depressing corporate investment. Homeowners feel poorer as home prices fall, which causes them to spend less. The typical American family will cut its spending by about 7 cents for every dollar in housing wealth it loses, so the potential decline of over $4.5 trillion in home prices could lead to a nationwide reduction in consumer spending of over $300 billion this year, enough to tip the economy into recession.
The Fed's role. The good news is that federal expenditures today as a percentage of gdp are about seven times greater than in 1929, which dramatically compounds the effective automatic countercyclical forces that are in place. Furthermore, the Fed today can ease monetary policy when it deems necessary; by contrast, gold standard laws in the early 1930s forced the Fed, counterproductively, to drain reserves from the banking system when foreigners redeemed dollars for gold.
What is to be done?
Left to itself, the market will wring out trillions of dollars of debt that had artificially driven up the price of real estate and financial assets—in effect, an economy that was living beyond its means.
The Fed cannot block this process. But it is necessary for it to proceed in an orderly fashion. This will involve central bank intervention unprecedented in scale and scope to break the vicious circle of fear and forced selling. The Fed must buy time, and only the Fed can do that on the scale required.
The most compelling need is to find additional capital for the financial system. Otherwise, the adverse feedback loop could intensify. The government has also unleashed the special housing agencies—Fannie Mae, Freddie Mac, and the Federal Home Loan Banks—to buy hundreds of billions of dollars of mortgage-backed securities, despite concerns over supporting unsustainable prices in, for example, residential real estate. Again, in order to stem panic and buy time, the Fed has no choice but to lend more money to more banks for longer periods against worse collateral.
Reader Comments
Intelligent person but
I do have some respect for Mort because of his views on Mclaughlin group. however what I find missing in articles like these is how to increase demand for housing. one is to let the prices fall more and more till more buyers find it affordable. The other is to fix the broken immigration system and to process residency a bit faster for legal immigrants (note - I mean legals who are already in the US ..because of the broken system it takes around 8 years for them to get a green card ..after paying around 15 thousand dollars in fees - (lawyer and other)).
A Most Shameful Article
I already knew that people who wield alot of power never told people the truth, but to suggest that the Fed, which is NOT the government but a PRIVATE institution controlled by PRIVATE banks(the seven largest shareholders are not even listed!), have MORE control over markets IS JUST SHAMEFUL.
IF you do not understand how a fiat money system works vs. a hard currency system, like the gold standard, then I will explain it to you.
If I deposit gold into a bank then that bank can put out loans on said gold as long as I keep it in that bank....that bank cannot put out more loans than it has in collateral b/c it would make the bank insolvent if everyone were to pull their gold back out. In this system, credit cannot just be created and this system gives the free market more stability b/c it puts more lending and credit restrictions on a bank than could ever be put on a bank by regulations written in a book.
Fiat money systems, like the Federal Reserve, work on a credit/debit system that makes every man, woman, and child be forever in debt to the Fed b/c they print money and lend it to banks on a percentage. This credit, however, is NOT backed by any collateral and is created for banks, basically out of thin air(but is based on a complicated algorithm that includes GDP, inflation, confidence of other central banks in the growth of our economy, and many other things), to artificially stimulate investment in whatever market investors think they can make a quick buck in. This "artificial credit" that is created can only benefit the first receivers of that credit b/c they are allowed to buy credit on loan and possibly make more money then they owe....which is not always the case as is true in any "bubble" for it is this artificial creation of credit that CREATES the bubble.
So it is the LACK of a gold system that creates monetary instability b/c the banks are allowed to control the flow of money, the direction of the economy, the direction of the government, and in effect basically control the ENTIRE country.
So, in summary, you are a FRAUD and you should be ASHAMED that you had enough gall to even write your column!
Hear! Hear!
Mr. Z -
What you suggest is, in concept, like allowing the DMV to regulate the way cars are built. They are tangentially connected, but allowing a government agency more power over the free market smacks of a losing ideal.
It would be wonderful to believe that the government can swoop in and fix the problems accrued by private lenders, and individuals - but in the end, it is in the market's best interest to allow these institutions, and again - individuals - to fail. I hear tell of hard-luck stories of people being given mortgages that knew they wouldn't be able to pay back - and I wonder, who signed the documents? I know there is a lot of fine print, but in all honesty, you are signing away a majority of your income for thirty (or more) years. I would imagine someone would make the effort to understand what it is they are signing. And if they don't, and sign regardless, they should be allowed - yes, allowed - to fail, lose their home and be sent on their way. That, to the best of my knowledge, is how the mortgage industry is designed: you promise, on the collatoral of your home, to pay on time, and in full. When you don't, you forfiet your home. Just one thought.
As for the multitude of your suggestions - they sound like so much Democratic tongue whapping. If there is so much need to help, and regulate, why has the system worked as it has for so long? Why the sudden need? And why not ask wealthy Democrats - who should line up for this one - just open their pockets and help others out?
I've got 60,000 in college debt, I'll take a check.
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