Wednesday, November 28, 2007

[Latest Global Dollar Liquidity measure: +14.1% annual growth rate; latest Endogenous Liquidity Index: -34.8%]

"Price Discovery", the new buzzword; the wisdom of Charles Plosser; Liquidity @ Financial Times.

[1] The new buzzword. "Price discovery" is the new buzzword at the Federal Reserve. This Hayekian notion is being relentlessly put forward —among others— by governor Randall Kroszner, who recently devoted an entire speech to this "process by which buyers and sellers' preferences, as well as any other available market information, results in the 'discovery' of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources". The lack of price discovery is the price participants are paying for the new, securitization-driven financial system with highly dispersed credit risk. [Randall Kroszner: "Risk Management and the Economic Outlook"; "Recent Events in Financial Markets", Federal Reserve Board]

[2] The wisdom of Charles Plosser (I). Unsurprisingly, the Philly Fed president and CEO takes up the issue of ... price discovery. Plosser is even more explicit: "This price discovery process is still underway, and it is likely to be some time before it is completely sorted out. It is important to recognize that the Federal Reserve cannot resolve this price discovery problem. The markets will have to figure this out. Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks. Indeed, in some circumstances, lowering interest rates may prolong the painful process of price discovery" (italics mine). There you have it. Markets will have to figure it out!

[3] The wisdom of Charles Plosser (II). Mr. Plosser's speech has been characterized as highly "hawkish". I beg to disagree. While he repeatedly stated that the Fed "must resist the temptation to respond to short-term, transitory disturbances" by "arbitrarily lowering interest rates" (on inflation expectations/moral hazard grounds), he also outlined his criteria for setting the Fed funds target. An exceedingly high target would result in the creation of "too little liquidity, leading to ... too little inflation or perhaps even deflation". Further, Mr. Plosser states that "is important to appreciate the fact that slow-growing economies exhibit real, or inflation-adjusted, interest rates that are somewhat lower than those of fast-growing economies". In other words, he appears to have the yield curve in mind. With the ten-year note yield 50 bps below the Fed funds rate target, there is clearly a case for more rate cuts from the central bank. [Charles I. Plosser: "Economic Outlook and Central Bank Policy", Federal Reserve Bank of Philadelphia]

[4] Liquidity @ Financial Times: Martin Wolf, monday morning quarterback? Martin Wolf describes modern banking as "an accident waiting to happen". The banking system, in his view, is dangeroulsy subsidized, prone to excessive risk-taking, etc. Bad, very bad! A strong whiff of monday-morning-quarterbacking lingers over this piece. If I remember correctly, Mr. Wolf used to describe the recent period of world economic growth as a "New Golden Age". Time to recall Schumpeter's words: "Stabilized capitalism is a contradiction in terms ... The history of capitalism is studded with violent bursts and catastrophes. It is no gentle process of adjustment but something more like a series of explosions". [Martin Wolf: "Why banking remains an accident waiting to happen", Financial Times] [Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007; web page; prologue; interview; podcast]

[5] Liquidity @ Financial Times: Illiquidity or insolvency? Max Keiser, founder of Karma Banque, says that banks engaged in a "global Ponzi scheme backed by what we now know to be largely counterfeit mortgage paper". He concludes: "Therefore it is insolvency along with its corollaries – opacity, misleading statements, dishonesty and larceny – that constitute the problem and illiquidity that is its symptom". [Max Keiser: "Problem with banks was insolvency", Financial Times]

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