Keynes and the Crisis

In Keynes’ General Theory, he explained that an equity market collapse could be blamed on either a weakening of confidence or of the state of credit — in modern parlance, these are referred to as “counter-party risk” and “liquidity risk” respectively. The importance of this observation, however, is given by Keynes subsequent assertion that “recovery requires the revival of both” (Keynes, 1936 [1973]: 158).

The point raised by Keynes is especially prescient given the current market turmoil. The realization that asset-backed securities were not worth what investors thought they were led to a collapse of both confidence and the state of credit. Financials were left wondering what the true size of their balance sheet was and therefore liquidity was in short supply, while simultaneously the increase in counter-party risk led these same institutions to be hesitant to lend. The result was a substantial increase in conventional measures of risk as reflected by the LIBOR-OIS spread and the TED spread as well as others. In an effort to ensure that both the collapse in confidence and of liquidity were reversed the Federal Reserve has taken drastic action. They have expanded the scope of the discount window through the Primary Dealer Credit Facility (PDCF) and have created the Term Auction Facility (TAF) to ensure that firms have the liquidity that they need. In addition, the federal funds rate was lowered precipitously to 2%. Thus, the major question is whether this has worked.

The conventional wisdom seems to be that the Federal Reserve has been moderately successful, but that they need to hold their course (i.e. not raise rates) to prevent a further exacerbation of the crisis. On the other hand, I have recently advocated a tightening of the federal funds rate in an attempt to stave off ever-growing inflationary pressures from a world awash in liquidity and therefore would like to submit the current data to closer analysis.

Currently the spread between the 3-month LIBOR (the London Interbank Offer Rate) and the Overnight Indexed Swap remains relatively high. Similarly, although the TED spread has gone down it remains elevated. In a recent paper by John Taylor and John Williams, they argue that these elevated risk spreads in the aftermath of the creation of the TAF suggests that it has not been successful. They may be correct, but I would like to float a different hypothesis. It is my view that the creation of the TAF and the subsequent creation of the PDCF have only satisfied one aspect of the recovery process, namely, an increase in liquidity. Whereas the programs increase the scope of the Federal Reserve’s role as lender of last resort thus ensuring that there is liquidity to be had, the programs have not succeeded in restoring confidence. In other words, the conventional measures of risk are reflecting counter-party risk, rather than liquidity risk. As the allusion to Keynes earlier highlights, it is not enough to start a recovery by merely providing liquidity; confidence must also be restored. Although the Fed had hoped that the creation of such programs would encourage firms to accept the same collateral, they have provided no such increase (or at least very little increase) in the state of confidence (as reflected in the still elevated conventional measures of risk).

If I am correct in my hypothesis, this would suggest that the rate cuts by the Federal Reserve have gone too far and have not contributed substantially to the increase in liquidity nor to the alleviation of the crisis. Under such circumstances, it would therefore prove prudent for the Federal Reserve to begin raising rates to stave off inflationary pressures rather than relying on others to do so. Unfortunately, my hypothesis also suggests that the crisis is here to stay for some time as the financials sort things out and until, ultimately, confidence is restored.

Originally published at The Everyday Economist and reproduced here with the author’s permission.

3 Responses to "Keynes and the Crisis"

  1. akmi   July 3, 2008 at 1:13 pm

    Rising inflation may push up inflation expectations which may push up mortgage rates. Will counterparties be more confident if mortgage rates were to stay low and reduce the risk of mortgage defaults and foreclosures? A Fed rate hike might stave off inflation but Fed officials seem to believe the domestic growth slowdown will moderate inflation. A rate hike may strengthen the dollar and weaken commodities but commodity demand growth outside the U.S. will remain strong enough to keep U.S. headline inflation high (and maybe later filter down to core inflation).

  2. Peter   July 4, 2008 at 9:41 am

    What about the possibility that the Fed lowered interest rates to save the banks, not the borrowers. The banks have increased their profits on normal activities because of the rate cuts. These cuts have not been passed on to borrowers. The point of the Fed’s move was to save our financial system from collapse. If they could not figure out a way to increase bank profits in the next year the banks were screwed, because they will continue having write downs for the coming quarters.Everyone knew rate cuts would kill the dollar and increase commodity prices but we did it anyway because the Fed had no choice. Option A do nothing and our entire banking system collapses because most banks are currently under water, Option B, lower rates and give the banks free money. Well, the money is not free, we as Americans are paying for it every day in higher prices.As for inflation, I don’t see it. I see higher food and energy prices, that is not inflation, that is increased costs of certain goods. Housing, down. Salaries, down. Consumer goods, down. Inflation would require higher wages to pay for the price of all goods rising. Since the American consumer is strapped prices can not rise on discretionary goods.