Strategeric Problem

What Paul Krugman says today:

...What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in stuff that is normally traded all the time — in particular, financial instruments backed by home mortgages — have shut down 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 the last few years, which in retrospect were as irrational as the dot-com mania. The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.

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

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

Investors were rattled recently when the subprime meltdown caused the collapse of two hedge funds operated by Bear Stearns, the investment bank. Since then, markets have been manic-depressive, with triple-digit gains or losses in the Dow Jones industrial average — the rule rather than the exception for the past two weeks.

But yesterday’s announcement by BNP Paribas, a large French bank, that it was suspending the operations of three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of “the complete evaporation of liquidity in certain market segments” — that is, there are no buyers.

When liquidity dries up, as I said, it can produce a chain reaction of defaults. Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution 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 anyone else to repay a loan, which makes things even worse.

And here’s the truly scary thing about liquidity crises: it’s very hard for 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 of a rate cut by the Fed before the end of next month at almost 100 percent. It can also lend money to banks that are short of cash: yesterday the European Central Bank, the Fed’s trans-Atlantic counterpart, lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty 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, the executive branch of the U.S. government could do to contain the crisis if the standard policies don’t work. But for a variety of reasons, not least the current administration’s record of incompetence, we’d really rather not go there...

And it's catching:

Market declines in Europe and New York Thursday sparked a similar rout today in Asia. Stocks in Japan, Hong Kong and Australia dropped by more than 2.5 percent, with South Korea’s benchmark dropping 4.27 percent. As investors sold off assets considered relatively risky, such as Philippine stocks, they bought those considered safer, such as Japanese government bonds. Asian currencies such as the Thai baht also retreated against the U.S. dollar and more liquid and stable currencies such as the Japanese yen.

“Everyone’s been talking about a credit crunch and not surprisingly it turned into one,” said Jan Lambregts, head of Asia research at Rabobank in Hong Kong. While Asian banks didn’t seem to be directly affected, he said, “the main problem is we don’t know who is bearing the losses and that kind of uncertainty is creating the situation that we’re in right now...”

The quandary faced by central bankers was illustrated nowhere better than in South Korea. After raising interest rates on Thursday in an attempt to discourage excessive lending by bankers, Korean central bankers today were reportedly attending crisis meetings on how to handle fears of a liquidity crunch...

Economic regulation works only for the components of the economy the government regulates. Banks weren't designed to deal with the problems they now face. In the 1990s, that AEI stalwart and $upreme Court wannabee Robert Bork said that the only way to restore Righteousness would be to re-create the Great Depression. It does seem, with Bu$hCo-Cheneyburton popularity in the 20 percentile, sodomy as popular as ever, and the TheoCon takeover of the country pretty much stalled that the Wise Old Men of Washington are entertaining just such ideas again.

And it may be Mr. Norquist, you have successfully drowned your government in your bath tub this time.