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On Friday, the Financial Times
reported Central
Banks Float Rescue Ideas. The article states that central banks are
considering plans involving the purchase of worthless or nearly worthless
mortgage-backed securities from banks. Shortly afterwards, Reuters reported Bank
of England denies mortgage purchase plan.
The FT writes,
Such a move would involve the
use of public funds to shore up the market in a key financial instrument and
restore confidence by ending the current vicious circle of forced sales,
falling prices, and weakening balance sheets.
The conversations, part of a broader
exchange as to possible future steps in battling financial turmoil, are at an
early stage. However, that such a move is being discussed at all indicates
the depth of concern that exists over the health of the banking system.
It shows how far the policy
debate has shifted in recent weeks as the crisis has spread to prime mortgage
assets in the US and engulfed Bear Stearns, the investment bank.
Sun 5pm PST, this just in:
Economist
Forecasts Central Bank Action
Central banks and governments in
advanced economies will be forced to buy mortgage-backed securities within
the next few months to stop the credit crisis, according to a former chief
economist of the European Bank for Reconstruction and Development.
"Central banks will be
managers for years to come of rather interesting portfolios," predicted
Professor Willem Buiter of the London School of Economics, as the Federal
Reserve and the Bank of England sought to play down conversations officials
have had regarding purchases of mortgage-related assets.
The Financial Times reported on
Saturday that conversations had taken place concerning such plans, as part of
a broader, early-stage exchange as to possible future steps in battling
financial turmoil.
But why does falling asset
prices constitute a "vicious circle"? Do falling prices of cars,
computers, or airline tickets constitute a problem? What's wrong with someone
getting a good deal? For the holders of assets, yes, but if you are an
investor (such as Warren Buffett) looking to buy assets cheaply, falling
asset prices are an opportunity. If some institutions who have excessively
leveraged themselves become insolvent, the underlying real factors continue
to exist. The financial assets are only paper claims to real things (or in
some cases paper claims to nothing). If the banks that holding paper assets
goes bankrupt, society as a whole has no fewer productive factors. Only the
ownership of these assets changes. How could this lead to destructive
macro-economic effects?
The reason is that the same
institutions that buy the assets create the money with which to purchase
them, out of nothing, a process that Charles Holt Carroll called the organization
of debt into currency. As Carroll perceptively wrote in the late 1800s:
When the creditors demand their
money, its debtors are called upon to pay money the bank never loaned, never
had to loan, and necessarily has not on hand to meet is running demand
liabilities: then comes the crisis that many writers call a
"panic." It is such a panic as the wasted sufferer feels whose
lungs are losing their power of inflation; it is no panic; it is the
inevitable crisis of death.
When loans that were made out of
fictitious currency default, the money that created the loan is destroyed.
When the supply of money contracts (deflation), there is downward pressure on
all prices, including the prices of other assets, and on the incomes of the
underlying entities that create the ability to pay back other debts. There is
a tendency, then, for the contagion to spread from bank to bank as debt defaults
destroy money, and money destruction causes more debt defaults. That is why
the unraveling of the credit bubble threatens to bring down the entire
financial system.
As Carroll wrote:
Contraction may begin it, but
the positive and negative poles of the scheme will very soon change places.
When bank accommodation fails, bankruptcy comes into play, soon takes the
lead, and one tumbler here and there knocks down a whole line, until the
securities, against which the deposits stand, fall, and the deposits with
them. Banks being pressed with their notes must redeem them, and avail
themselves of their securities in the hands of the Comptroller to purchase
greenbacks or specie.
And
But when any such scheme shall
be put in operation, its two forces or elements, so to speak, will
immediately change places. It will not long be the contraction of the
currency that will cause the bankruptcy, but the bankruptcy that will
contract the currency.
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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