Fed puts politics over economics; credit bubble results

The current international credit crisis is a creation of the central banks, and primarily Alan Greenspan. Greenspan gave the sellers of high-risk high-return an essential guarantee that if they borrowed money to leverage the profits from the risky investments, he would bail them out by lowering interest rates if the market went against them.

Here is Bill Fleckenstein at MSNBC Money on the subject:

"The global credit bubble is bursting. This bubble is primarily leverage financing for owning risky assets. The people who were responsible for what happened played with other people's money, marketed arcane financial products with false promises of fat profits, but stuffed their own pockets with big bonuses. Neither these masters of the universe nor their greedy but naive investors deserve to be bailed out. They deserve what is coming to them.

"The central banks should focus on price stability, not financial market stability, and should provide liquidity only to contain the multiplier effect of the bubble bursting on the economy. Nor should central banks stimulate to avoid recession at any cost. Business cycles are not bad. Excesses must be followed with cleansing. . . .

"Markets have been taking more risk than they should because they believe that central banks will come to their aid during times of crisis, like now. The penchant of Alan Greenspan, former U.S. Federal Reserve chairman, to flood the market with liquidity during financial instability is the genesis of this 'central bank put.' As long as this expectation remains, financial bubbles will occur again and again. Now is the time to act. Let the crooks go bankrupt. Central banks should bury the Greenspan 'put' for good."

Why would Greenspan do this?

Simple. Electing the Republican George Bush was more important to him than was rationally managing the money supply for the American economy.

Wait to see if the Fed bails out the speculators. That will tell us of Ben Bernake is continuing Greenspan's practice of protecting the speculators.

Nourial Roubini makes the point that there is a difference between being illiquid and being insolvent. A debtor in illiquid if they could pay back their debts over time if their creditors would give them time by restructuring the debt. A debtor is insolvent if they cannot repay their debts over time even if they were given the time by their creditors.

An illiquid organization is in a temporary cash crunch but is an otherwise economic viable organization. Chrysler was in such a situation several decades ago. They could not pay their debt at the time, but with a bailout they were able to completely pay off their debts without costing those who bailed them out anything. Enron was not an economically viable organization. it was insolvent. It could not be bailed out. With that in mind, consider:

Insolvent and bankrupt households, mortgage lenders, home builders, leveraged hedge funds and asset managers, and non-financial corporations. This is not just a liquidity crisis like in the 1998 LTCM episode. This is rather a liquidity crisis that signals a more fundamental debt, credit and insolvency crisis among many economic agents in the US and global economy. Liquidity runs can be resolved by the liquidity injections by a lender of last resort: in the cases of the liquidity crises of Mexico, Korea, Turkey, Brazil that international lender of last resort was the IMF; but in the insolvency crises of Russia, Argentina, and Ecudaor the provision of the liquidity by the lender of last resort – the IMF – only postponed the inevitable default and made the eventual crisis deeper and uglier. And provision of liquidity during an insolvency crisis causes moral hazard as it creates expectations of investors’ bailout.
[Emphasis mine - Editor WTF-o]

I would not at this time predict an insolvency crisis, but it should be very clear that Alan Greenspan was papering over problems in the economy in order to reelect George Bush in 2004. By doing so he made the current problems deeper and uglier. The only question is how severe the underlying economic problems - other than merely illiquidity - really are. The central bankers really don't want the level of the problems to be seen. If it all comes out at once right now there is a chance that the credit markets would simply shut down for a period of time. So they want to try to talk nice while they are secretly cleaning up the mess in the background.

Let's all hope that Ben Bernanke practices economics as a central banker rather than politics as a Republican like Greenspan did. Oh, and let's hope that there is a reasonable chance remaining after Greenspan's economic mismanagement for the repairs to work.

See my prior posts

• More mortgage loan problems
  August 12, 2007
• Credit crunch spreads outside U.S.subprime markets to the rest of the world.
  August 10, 2007