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“Wise men talk because they have something to say; fools, because they have to say something.”     Plato

October 7, 2008

Fed Opens Spigot With Up To $900B $1.3T More

by Brad Warbiany

With the reverberations of the Congressional fight over the $700B bailout still shaking Capitol Hill, the lingering question has been whether that $700B would be enough to do any good.

Nope. They’ll need at least double that. And Congress isn’t voting on this plan:

The Federal Reserve announced Tuesday a radical plan to buy massive amounts of short-term debt in a dramatic effort to break through a credit clog that is imperiling the economy.

The Federal Reserve, invoking Depression-era emergency powers, will buy commercial paper, a short-term financing mechanism that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls.

The Fed said it is creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program up and running soon, Fed officials said.

Fed officials said they’ll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify.

And lest anyone be confused, this is not what went through Congress on Friday:

The Treasury will provide money to the Federal Reserve Bank of New York to support the new program, the Fed said. Fed officials would not say how much but believed it would be substantial. The money would not come from the $700 billion financial bailout President Bush signed into law on Friday.

Bernanke, a student of the Depression, took one lesson away from the 1930s. Never let liquidity dry up. He’s going to inject so much grease in the system that it will be FORCED away from seizure. What remains to be seen, though, is if that grease will cause it to spin right off the axle.

The current credit crunch is a largely deflationary phenomenon. Too much leverage existed in the system, and with our fractional reserve lending system, that led to too much money floating around.

The healthy way to let leverage unwind is to allow that fake wealth to evaporate. However, this is a very painful exercise. Leverage-induced inflation sends false signals to the market suggesting that natural demand for certain products (housing in this case) is increasing, and jobs and companies spring up to meet that demand. As the leverage unwinds, the money dries up, and people in those sectors are left out of a job looking for something to do.

The unhealthy way to unwind leverage is to flood the market with enough liquidity that the base of the lever expands. If you’re leveraged at 20-1, and the government steps in and loans you new capital while buying your bad assets, you can increase your capitalization and may only be levered at 10-1 while your actual holdings haven’t decreased. This is what the government is trying to do. The danger, of course, is that the new money injected into the system just adds to the leverage, and we end up in a hyperinflationary depression.

Many people I’ve spoken to who are involved in financial matters are saying things like “I’ve never seen anything like this before. The market is acting in completely unprecedented ways.” At the same time, we have a government that is so desperate to stave off another 1930s depression that they’ll sacrifice any sense of fiscal discipline or monetary stability. It sure is going to get interesting!

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6 Comments

  1. Interesting as in scary as hell.

    I’m beginning to feel like we’re living through something that won’t be completely understood until someone somewhere, probably in China, writes the history of it 50 or 100 years from nwo.

    Comment by Doug Mataconis — October 7, 2008 @ 9:26 am
  2. [...] at The Liberty Papers, Brad Warbiany lays out pretty starkly what could go wrong with the Fed’s new plan: The current credit crunch is a largely deflationary phenomenon. Too much leverage existed in the [...]

    Pingback by Below The Beltway » Blog Archive » The Fed Takes Another Radical Step — October 7, 2008 @ 10:03 am
  3. Thanks for posting this.

    If a certain next administration gets its way, I predict we’re going to be faced with the double whammy of higher taxes and high inflation.

    Hmm, when have we witnessed this before, and how successful was it?

    Oh yeah. 1970s. And not at all.

    Comment by BigLiberty — October 7, 2008 @ 10:35 am
  4. BigLiberty,

    Well, the one thing that neither McCain nor Obama are admitting publicly is the fact that the economic crisis is pretty much going to put an end to those grand plans they keep talking about.

    Comment by Doug Mataconis — October 7, 2008 @ 11:04 am
  5. Well, the one thing that neither McCain nor Obama are admitting publicly is the fact that the economic crisis is pretty much going to put an end to those grand plans they keep talking about.

    Are you fer serial? Are you implying that the lack of ability to pay for these grandiose programs they want to impose upon us will prevent said imposition? What on earth do you mean by this?

    Comment by thomasblair — October 7, 2008 @ 11:35 am
  6. I saw an article today, by Veronique de Rugy and Philippe Lacoude, that had a far better idea of how to use the $700 billion if we had to use the money. Obviously there were far better ways without using any or very little taxpayer money and this article addresses that as well. What they said was that instead of giving the $700 billion to the companyies that brought us into this mess, instead give approximately $3,600 to every taxpayer (191 million) and they would have to put this money into a retirement account. A lot of this money would go into money market accounts for safety. This would alleviate some of the credit crunch as this money would be able to be lended out to the most deserving businesses and individuals. Other money would go into mutual funds or even into stocks that have taken severe hits. The most deserving companies would get the most money. This would help to stabilize the stock market and bring some confidence back to the market. Some might go into commodities, such as gold, for a few people expecting things to continue to get worse and looking for the inflation that will surely come. This plan would have certainly had more backing and confidence with main street than the plan that was passed. The problem with this plan from a political standpoint is nobody is getting their wheels greased. Wall street and banks will only be getting money indirectly so there will be no favors that need to be paid from either side. It just isn’t corruptable enough to gain favor with politicians.

    Comment by TerryP — October 8, 2008 @ 2:18 pm

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