The Liquidity Tsunami

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Includes: DIA, QQQ, SPY
by: Brad DeLong

Michael Mussa argues that this is one slowdown in which nobody can claim that the Federal Reserve has been "behind the curve" as far as its response to the slowdown in the pace of real spending, demand, and production is concerned. Indeed, the liquidity tsunami the Federal Reserve and its companions have unleashed upon global credit markets is truly extraordinary:

  • Dropping nominal interest rates on the Treasury assets truly free of nominal risk to levels at times only a fraction of a percent per year.
  • Guaranteeing the unsecured debt of every major investment bank in America.
  • Guaranteeing (or, rather, somehow inducing the Bank of America to guarantee) the unsecured debt of Countrywide.
  • Unleashing Fannie Mae and Freddie Mac to borrow an extra half a trillion dollars or so, and spend it buying up and managing mortgages and so profiting from the spread between mortgages and Treasuries.

If all this isn't enough to keep the flow of funds to finance investment steady and so save America from large-scale cyclical unemployment, I will be genuinely surprised.

From Michael Mussa (2008), "Global Economic Prospects 2008/2009: Hoping for a Global Slowdown and a US Recession":

The extent of this crisis in credit markets is even more remarkable in view of the exceedingly aggressive actions taken by the Federal Reserve and the important but less aggressive actions of other leading central banks. Contrary to the nonsense spoken by many financial-market commentators, the Federal Reserve has not been "behind the curve" in its policy response. In fact, the easing of US monetary policy in the present possible recession has far outstripped the pace of easing in past actual recessions. On top of this, the Federal Reserve has recently taken truly extraordinary actions to extend specific liquidity support to a wide range of US financial institutions.

The official explanation for these extraordinary actions is not that they are motivated primarily by the desire to protect financial institutions from losses but rather to head off the risk of major damage to the general economy spreading from difficulties in the financial sector. So far, however, there is little indication that the general economy is suffering much damage from the credit market turmoil—beyond some deepening of the downturn in US residential investment. In particular, the present slowdown in the US economy and around the world is not much more than what we would normally have expected in view of falling home values, higher food and energy prices, and other developments aside from the turmoil in credit markets.

Does this imply that the Federal Reserve, in its efforts to protect the financial sector, has overreacted to the credit market turmoil? Has it eased too aggressively, unduly raising the risk of inflation down the road? Has its rescue of the financial sector by cutting massively the cost of funds and the provision of specific liquidity support generated far too much moral hazard relative to the value of the protective effect of these actions against real hazards faced by the general economy?

At this point, the answers to these questions are not entirely clear, but two conclusions can be reached with high confidence. First, given the massive easing already undertaken by the Federal Reserve and the likelihood of some modest further easing, the US economy now needs to undergo at least a near recession if the Federal Reserve's easing is not to be excessive. Second, if the Federal Reserve's highly aggressive actions have really been warranted to protect the economy from substantial harm, then deep reforms of the financial system, including the Federal Reserve's policies and practices, are clearly needed to reduce the likelihood of such problems in the future. The Federal Reserve cannot pose only as the hero riding to the rescue of the economy and the financial system. Its role as one of the villains whose earlier actions and inactions contributed to the present crisis needs to be fully and carefully assessed.

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