Very Scary Things

I'm sure many have been following the financial meltdown over recent weeks. Financial Times video diarist John Authers ended his report yesterday saying "we are living in very dangerous times." Below is Paul Krugman reiterating Auther's frightening revelation that the liquidity tap seems to be turning off.

NY Times, August 10, 2007Op-Ed ColumnistVery Scary ThingsBy PAUL KRUGMAN

In September 1998, the collapse of Long Term Capital Management, a gianthedge fund, led to a meltdown in the financial markets similar, in someways, to what's happening now. During the crisis in '98, I attended aclosed-door briefing given by a senior Federal Reserve official, wholaid out the grim state of the markets. "What can we do about it?" askedone participant. "Pray," replied the Fed official.

Our prayers were answered. The Fed coordinated a rescue for L.T.C.M.,while Robert Rubin, the Treasury secretary at the time, and AlanGreenspan, who was the Fed chairman, assured investors that everythingwould be all right. And the panic subsided.

Yesterday, President Bush, showing off his M.B.A. vocabulary, similarlytried to reassure the markets. But Mr. Bush is, let's say, a bit lackingin credibility. On the other hand, it's not clear that anyone could dothe trick: right now we're suffering from a serious shortage of saviors.And that's too bad, because we might need one.

What's been happening in financial markets over the past few days issomething that truly scares monetary economists: liquidity has dried up.That is, markets in stuff that is normally traded all the time -- inparticular, financial instruments backed by home mortgages -- have shutdown because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst,however, it could cause a chain reaction of debt defaults.

The origins of the current crunch lie in the financial follies of thelast few years, which in retrospect were as irrational as the dot-commania. The housing bubble was only part of it; across the board, peoplebegan acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans, which allowedpeople without the usual financial qualifications to buy houses, and theeagerness with which investors bought securities backed by these loans.But investors also snapped up high-yield corporate debt, a k a junkbonds, driving the spread between junk bond yields and U.S. Treasuriesdown to record lows.

Then reality hit --- not all at once, but in a series of blows. First, thehousing bubble popped. Then subprime melted down. Then there was a surgein investor nervousness about junk bonds: two months ago the yield oncorporate bonds rated B was only 2.45 percent higher than that ongovernment bonds; now the spread is well over 4 percent.

Investors were rattled recently when the subprime meltdown caused thecollapse of two hedge funds operated by Bear Stearns, the investmentbank. Since then, markets have been manic-depressive, with triple-digitgains or losses in the Dow Jones industrial average =97 the rule ratherthan the exception for the past two weeks.

But yesterday's announcement by BNP Paribas, a large French bank, thatit was suspending the operations of three of its own funds was, ifanything, the most ominous news yet. The suspension was necessary, thebank said, because of the complete evaporation of liquidity in certainmarket segments -- that is, there are no buyers.

When liquidity dries up, as I said, it can produce a chain reaction ofdefaults. Financial institution A can't sell its mortgage-backedsecurities, so it can't raise enough cash to make the payment it owes toinstitution B, which then doesn't have the cash to pay institution C

and those who do have cash sit on it, because they don't trust anyoneelse to repay a loan, which makes things even worse.

And here's the truly scary thing about liquidity crises: it's very hardfor policy makers to do anything about them.

The Fed normally responds to economic problems by cutting interest rates-- and as of yesterday morning the futures markets put the probability ofa rate cut by the Fed before the end of next month at almost 100percent. It can also lend money to banks that are short of cash:yesterday the European Central Bank, the Fed's trans-Atlanticcounterpart, lent banks $130 billion, saying that it would provideunlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much oftheir effectiveness. Reducing the cost of money doesn't do much forborrowers if nobody is willing to make loans. Ensuring that banks haveplenty of cash doesn't do much if the cash stays in the banks' vaults.

There are other, more exotic things the Fed and, more important, theexecutive branch of the U.S. government could do to contain the crisisif the standard policies don't work. But for a variety of reasons, notleast the current administration's record of incompetence, we'd reallyrather not go there.

Let's hope, then, that this crisis blows over as quickly as that of1998. But I wouldn't count on it.