Thursday, March 26, 2009

But Will They Work?

Or maybe a better question would be, what about the side effects or unintended consequences?

Right now the U.S. government is attempting to address the financial crisis with two unprecedented programs, each of which explores new ground. The Treasury is unrolling the much criticised Troubled Asset Relief Program, to great and sensible criticism that it will enrich a few speculators by guaranteeing the downside of their investment to encourage them to overpay for toxic assets and free up bank balance sheets. Over course, even if the assets change hands at prices above what they would clear in a market transaction, that price is likely to be below their carrying value on the books of the institution owning them, which will necessitate further writedowns and result in additional capital impairment.

Variation on TARP have been kicking around for six months. My sense is that six months ago there was far more confidence than there is today about the capacity of financial institutions to raise additional capital. I will predict that TARP will unfold as follows:

1. A few deals will be done.

2. The writedowns will be horrific, and the impairments will occur not only at the institutions selling their exposures at an agreed price but at all institutions holding similar instruments (the accounting rules are being changed even as I write this so that won't automatic, but it will nonetheless be very difficult to avoid).

3. The insolvency of the capital markets institutions will be again demonstrated, and piecemeal nationalization will proceed apace.

4. If the housing markets continue to deteriorate (in the sense of declining house prices, not levels of real estate activity), the deals that are done will end up underwater.

The other big new initiative is, of course, quantitative easing. I think this boils down to one arm of the government (the Fed) buying the debt securities of a second arm of the government (Treasury), and, when the dust settles, proceeds from the short term obligations of the Fed being 'invested' in the long-term obligations of the Treasury. It vaguely resembles the operation of the Social Security Trust Fund. I believe the idea is to gain some control over the yield curve, and it may succeed in doing that. But it is premised on the ability of the Fed to fund its operations at the short end of the curve, which has never been in doublt, but then, an operation like this has never been tried.

My sense is that in the intermediate term, there will be either, a currency crisis, a surge of domestic inflation, or both. Just because deflation is currently a bigger threat than inflation doesn't mean inflationary possibilities in the longer term can be dismissed out of hand (though the argument is made from time to time). And my sense of the currency issue is that the effects of quantitative easing will be subsumed in a greater set of issues.

But, 15 years ago James Carville, then working in the Clinton White House, memorably said that when he died he wanted to come back as the bond market, because everybody was scared of the bond market. I get the feeling the government has lost its fear of the bond market and, if that's the case, that would be a bad thing.

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