Thursday, October 09, 2008

What if the money didn't flow no matter how far rates were cut?

That's how things are looking

Paul Krugman

"..the relationship between Fed funds rates and the rates most businesses actually pay is very weak right now, thanks to the messed-up state of the financial system.

A quick illustration: in early July 2007, before the crisis, the target Fed funds rate was 5.25% and the rate on 30-day commercial paper issued by less-than-sterling borrowers — was 5.4%. On Monday of this week, the target Fed funds rate was 2%, down 325 basis points from pre-crisis levels, but the CP rate was 5.61% — up from pre-crisis levels.

So will this latest rate cut make any difference to borrowers? Maybe — but only to a few of them. We’re way past the point at which conventional monetary policy has much traction."

Michael West in an excelent column this morning points out the same thing:

"The TED spread - the purest indicator of confidence which measures the gap between US Treasuries and the rate at which banks lend to each other - blew out to 403 basis points while both overnight and three-month Libor widened too.

In other words, even a round of global rate cuts could not lure banks back to the money market. Unless this radical collective effort begins to stem the losses and restores some semblance of stability, we will soon descend into sovereign risk territory."

If, regardless of how cheap money "should" be, the people with it won't part with it except at an extortionate rate, money will scarcely flow at all.

Even on the ordinary foreign exchange market Australians are suddenly finding it hard to buy US dollars. A week back we could buy almost one for an Australian dollar - now we can only buy two-thirds of one. Here's a tip - don't think about traveling overseas.

Sound familiar? It happened in Japan for a decade...
no-one would part with money at any reasonable price.

As Krugman wrote evocatively at the time:

"The state of Japan is a scandal, an outrage, a reproach. It is not, at least so far, a human disaster like Indonesia or Brazil. But Japan's economic malaise is uniquely gratuitous. Sixty years after Keynes, a great nation - a country with a stable and effective government, [in Japan's case] a massive net creditor, subject to none of the constraints that lesser economies face - is operating far below its productive capacity, simply because its consumers and investors do not spend enough. That should not happen; in allowing it to happen, and to continue year after year, Japan's economic officials have subtracted value from their nation and the world as a whole on a truly heroic scale."

Economists call this a liquidity trap.

Krugman proposed a way out so unconventional that to do it would turn everything on its head.

Heaven forbid that the time is coming when we need to deliberately create worldwide inflation. Oh my.