Posted by WARREN MOSLER on 17th December 2008
Deleveraging involves nothing more than ‘reintermediation’ back to the banking system (as described in more detail previous posts).
The government has failed to facilitate this transition back to a banking model to allow it transpire in an orderly fashion.
All that needed to happen was for credit spreads to go to levels that represented competitive returns on equity for banks, as banks picked up loans and securities no longer wanted by the non bank entities.
The move to mark to market from mark to model for banks, however, effectively added ‘spread risk’ to holding longer term loans and securities.
This mark to market risk also effectively raised bank capital requirements (as required by bank investors) in order to invest in the suddenly higher volatility investments.
This also increased the risk to investors of banks already holding securities that were subject to mark to market accounting.
The Fed allowed this risk to interfere with banks ability to fund their liabilities, as the Fed lends to member banks only against specific collateral.
Faced with a potential liquidity crisis, banks were compelled to respond by restricting lending that would otherwise have been considered profitable.
This led to the (continuing) downward spiral of the real economy.
The downward spiral is also characterized by a general (deflationary) inventory liquidation of housing and commodities.
I have been proposing (for the last 15 years) the Fed as Congress to remove the collateral requirement for member bank borrowing (it’s redundant in any case).
I have also proposed they extend their lending to member banks to include longer dated lending to set the term structure of rates as desired.
The Fed continues to slowly move towards this ‘target’ with it’s ‘new lending facilities’ and polices, but it continues to fall short.
The failure to act on the mark to market issue keeps risk for bank shareholders ‘artificially’ elevated which keeps credit spreads wider than otherwise.
I have also stated that while taking the right steps to facilitate the ‘great repricing of risk’ and the reabsorbtion of lending by the banking system would end the ‘financial crisis,’ it does not address the accelerating shortage of aggregate demand that’s been evidenced by rising unemployment and the widening output gap.
The near universal belief that lower interest rates sufficiently add to aggregate demand to restore output and employment and the numerous ‘deficit myths’ have delayed the substantial fiscal adjustment required to sustain aggregate demand at full employment levels in the current environment.
I have therefore proposed a ‘payroll tax holiday’ where the Treasury makes all FICA, medicare, etc. payments for employees and employers, along with a $300 billion revenue sharing program for the States to immediately fund operations and infrastructure programs.
Additionally, any economic recovery not associated with a program to reduce crude oil consumption risks a sudden shortage of supply and re escalation of prices.
Our govt’s ongoing mismanagement of the economy since q2 08 can be entirely attributed to a fundamental lack of understanding of our monetary system by govt, the mainstream financial and academic economic community, and the media that promotes this misunderstanding to the political leadership and general public.