The Invisible Hand and the Central Banks Handouts

By Travis Fast

What a week hey! Do you remember that econ class where right after you were introduced to the invisible hand in the form of some bullshit general equilibrium model and then you were led to the inextricable conclusion that there is no free-lunch? And can you recall in that ideological daze masquerading as value free and clear thinking rigour you still could not square your education with the reality which appeared in the business pages?

Well this week is a particularly bad week for those still clinging to an ontology of capitalism which requires little state intervention. No less than 285 billion US dollars worth of liquidity was pumped into the markets on Thursday and Friday with the ECB kicking in a whopping 213 billion and the US Fed kicking in another 62 billion. And the markets want more! (See this weekend’s WSJ and FT for a fuller account).

But that is not all; the Fed did not just open the window wide open, it did not just provide short term liquidity, it actually directly bought morgage backed securities. That is right folks the Fed is propping-up prices in the securities market. And I thought Liberal Market Economies (LMEs) did not require any form of coordinated government intervention. I wonder if the executive officers are going to get paid according to their marginal contribution this year. Don’t hold your breath that tends to only work in one direction.

Moreover, I doubt we are going hear too many REAL economists cry about the massive government intervention (Austrians do not count as REAL economists) into the markets. Nor are we likely to hear too many cries to let the market choose its own equilibrium. The situation will of course be different if this “perfect financial storm” does real damage to the real economy and real workers start hitting the unemployment line.

Then you can bet when the first bright politician suggests state intervention into labour markets we will be retold some bullshit story about the invisible hand, Say’s Law and the litany.

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8 thoughts on “The Invisible Hand and the Central Banks Handouts

  1. Please, explain what ‘pumped into the markets’ means. Is it actual money? Who gets it?

    If actually buying mortgage-backed securities is unusual, what kind of pumping is ‘usual’?

    I read here a lot. And understand more than I usually do of such matters.

  2. «This post has bee modified»

    PS. I get that when capitalist are faced with a crisis along with the financial architecture upon which voters are dependent it is ok for the central banks to step in. That was exactly my point. A crisis for capitalists is always a crisis for workers. Too bad the reverse is not also true. Why do you think that is?

  3. Fern those are great questions. A central bank has several tools through which it can manipulate the markets.

    The most basic is by setting reserve requirements. Reserve requirements refer to the amount of actual cash or such like that private banks must hold in relationship to their outstanding commitments. One of the things that has happened since deregulation is that reserve requirements have been decreasing.

    Another tool central banks have is their “window.” The window refers to the ability of private banks to take loans from the central bank to cover their present demands for cash. The bulk of the liquidity being pumped into the markets on Thursday and Friday was in this form albeit with some special arrangements. But even here if the private bank goes under and can’t meet its obligation to the Central Bank (CB) Johnny tax-payer picks up the tab.

    The other, albeit more extraordinary, tool the CB has in its armoury of market management is to directly intervene in the securities markets by buying actual securities in an attempt to stabilize the value of securities (note the Japanese CB did this a lot in Japan’s recent dog days).

    What Stephen fails to mention in his assessment of the correct policy choice for central banks is that governments failed to set up a regulatory environment which dissuaded financial actors from creating the kind of “shit storm” which is presently working its way through the markets. And I should add that Johnny tax payer is now assuming a lot of what was suppose to be private risk. And what he, Stephen, therefore also fails to mention is the problem such public intervention creates in terms of the “principle agent.”

    Principle agent theory states that private actors must bear the consequence of the fullness of their choices otherwise they will not assess risk appropriately and prices will become doggy. So what lesson have the financial geniuses learned from this crisis? That they can be overcome with irrational exuberance and the nanny state (read you and me) will bail them out? Hmm once again I can’t square my aborted econ training with reality!

  4. Ha. Let’s see if I got it. These private banks make a bunch of decisions about lending money to others. On which, presumably, they expect to make profit. But, shit happens. The value of their investments sink or shiver or whatever and the BC steps in to cover their asses? With Johnny and Janey Taxpayer’s dough? Which might be pissed up various private ropes? So these principle agents may not bear the full consequences and thus learn from their mistakes? But rather, just keep on doing this?

    Hey, I’ve got a nephew with some humungous student loans to pay off. . .

  5. Yah fern you got the basic pith and substance of the matter. Just remember that for the academic economists the issue is the cost to all of society not your single solitary brother (which is kinda odd because for the REAL economists single individuals are prior to society). But then Irony was never really (for the last 120 years anyway) in what their training consited of.

  6. Fern just to clarify, the central banks’ move is not “normal”. The last move like this was September 11th. Investors that make bad decisions, like those with junk securities, have and will lose money.

    The issue that Travis is raising is not related to the injection itself (which is normal and needed to achieve the banks’ target interest rate) but rather their acceptance of risky securities.

    Stephen, you support the central banks move — are you speaking specifically about accepting mortgage backed securities or the move in general?

  7. Well hold on: the injection was not merely about achieving the banks target rate. As Delong pointed out such an injection by the FED amounted to an annualized rate of growth of something like 2000 %. So as Delong put it: a significant liquidity event indeed. And the Feds stated policy prior to Thursday of last week was that they saw inflation on the horizon along side a week dollar but were nonetheless going to stay on the side-lines. That much liquidity was about the system not interest rates per se. Moreover, accepting mortgage backed securities while appearing odd is still inline with the FEDS tacit consent for the securitisation of risk.

    The issue that tweaks me is that the central banks are now fully in the game of making security prices. Besides the issue of how bad this makes text book pricing theory look there is the additional problem that the FED now has a direct interest in valuations.

    This has a correlate in the massive Chinese dollar holdings which are playing a big role in sustaining the value of the US dollar.

    This is all fine from a political economy perspective but it does not make much sense from a fundemental theorem POV. And there is of course the irony that the present crisis was partly a function of excess liquidity sloshing around which led to irrational exhuberence and which was remedied by pumping in still more liquidity.

    We will see just how much Johnny tax payer is going to have to work off over the next couple of years.

  8. Overall I agree with the asset pricing comment. But it is important to note that the Feds liquidity injection was relatively minor compared to ECB’s. FT says that the Fed’s $24B is twice the normal amount.

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