Wednesday, August 27, 2008

Jackson Hole paper - much ado about nothing

Franklin Allen in his paper "The Role of Liquidity in Financial Crises" presented at Jackson Hole 2008, looked into the role of financial intermediaries and the markets in providing funds to businesses and households in the context of the 2007 financial crisis. In section II of his paper, Liquidity and the Crisis, he concludes:

"Economic growth remained slow in the first half of 2008, and the persistent weakness in the housing market together with the tightened conditions for credit of businesses and households also weakened the projections for the second half of the year."

Unfortunatelly he does not provide any data that would support the link of strained liquidity provisons from financial intermediaries to said businesses and households and the weakening economy. It is of course perfectly understood if businesses can not finance their liquididty needs by obtaining loans from financial intermediaries theses businesses will have no alternative choice other than file for bankruptcy and this would in the end effect aggregate demand. But Franklin even admits that there are no obvious lending restrictions for businesses and households at this point in time.

"Credit has remained available to the business sector so far, but household borrowing has slowed. Similar changes are occuring in the UK and Europe."

We have reffered to this in a previous post. The ECB has included the "dynamism of loans to non-financial cooperations" in their policy statemets as an argument for raising interest rates in July 2008. The "haircut" on financial debt securities that occured between May 2007 and April 2008 (as shown in the chart below) has so far not significantly impared the availability of loans outside the mortgage arena. It stand to reason that the current slowdown in the economy has its origin not in the credit market. The fact that the Federal Reserve as the only major central bank has lowered interest rates by 325 basis points to 2 percent during this financial crisis is not reason enough to believe otherwise.

click to enlarge

The Fed of course has argued that rate cuts were necessary to counter weakening eonomic growth. By doing so the Fed acts more like the cyclist who makes a mistake and unexpectedly sheers out of line causing his fellow bikers to trip over one another. As the only one left standing he celebrates his victory.

Weakening economic growth coupled with rising unemployment and rising bankruptcies is far more likely to be the result of high inflation than limited liquidity provisions and the Franklin paper did nothing to tilt this in favour of financial intermediaries and the Federal Reserve.

source: The Role of Liquidity in Financial Crises

Franklin Allen, Jackson Hole 2008

read also: CPI at 2% at the end of 1971 - Mr. Bernanke more pragmatism please!
Friday, August 22, 2008

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