Radical Solutions for a Crazy Economy

By Nouriel Roubini, Forbes. Posted November 28, 2008.

Things are even worse if the debtor had borrowed to finance the leverage purchase of assets whose prices are now falling. Suppose you are a household who borrowed at a 5% mortgage rate to purchase a home whose price is now falling at an annual rate of 15%. The effective real interest rate that you are facing on your debt is not 5% but a whopping 20% (the sum of the 5% mortgage rate plus the 15% fall in the price of the underlying asset).

In all of its manifestations, debt deflation sharply increases the risk that borrowers will be forced to default on real obligations that they cannot service. Thus, debt deflation is associated with a sharp rise in corporate and household defaults that create a spiral of deflation, debt deflation and defaults.

"Crazy" Monetary Policy to Address the Liquidity Trap and a Severe Liquidity and Credit Crunch

To address the increase in real short-term market rates, the Fed and other central banks have already undertaken quite unorthodox monetary policy moves. To address the even more severe increase in real long-term market rates, the Fed and other central banks will have to undertake even more radical and unorthodox policy actions.

The widening of the real short-term market rates has been addressed by creating a whole series of new liquidity facilities. Indeed, the Fed and other central banks that used to be the "lenders of last resort" have become the "lenders of first and only resort," as banks don't lend to each other, banks don't lend to non-bank financial institutions and financial institutions don't lend to the corporate and household sectors.

However, in spite of the Fed becoming the lender of first and only resort (even the corporate commercial paper market is now being propped by the new Fed facility), there are still major problems that remain seriously unresolved in short-term money markets and short-term credit markets. Banks and other financial institutions are still not lending to each other in spite of lower spreads as they need the liquidity received by the Fed and they worry about the solvency of their counterparties; only banks and major broker dealers have access to these facilities and thus most of the shadow banking system does not have access to this Fed liquidity; market spreads are still rising and the availability of short-term credit is becoming tighter as banks increase interest rates on credit cards, student loans and auto loans and make such loans scarcer; only rated investment-grade firms have access to the commercial paper facility, leaving millions of speculative grade or non-rated firms in an even bigger liquidity and credit squeeze; and finally, the securitization of credit cards, auto loans and student loans is currently dead.

This is why a desperate Treasury is starting to think about using the remaining TARP funds to directly unclog the unsecured consumer debt market and the securitization of such debt. Desperate times required desperate and extreme actions.

Even "Crazier" Policy Actions are Required to Reduce Long-Term Market Interest Rates

But even more desperate monetary actions are needed to address the increase in real long-term market rates. These actions are needed to prevent deflation from setting in, to reduce the credit spread (the difference between long-term market rates and long-term government bond yields) and to reduce the yield-curve spread (the difference between long-term government bond yields and the policy rate).

There are a number of tools that the Fed could use to reduce the yield-curve spread when the Fed Funds rate is already down to zero. First, the Fed could commit to maintain the Fed Funds rate at zero for a long period of time. Even this, however, may not be sufficient to reduce long yields on safe assets as such long yields also depend on liquidity premiums and risk premiums that will not be affected by an expectation of future short rates. Greenspan discovered the "bond market conundrum," when raising the Fed Funds rate from 1% to 5.25% did not much change long rates; and Bernanke rediscovered this conundrum, when reducing the Fed Funds rate down to 1% failed to significantly reduce long rates.

Such long rates depend in part on the global supply of savings relative to the demand for investment; thus they are not likely to be strongly affected by current and future expected policy rates.

Second, the Fed could do what it last did in the 1950s: directly purchase long-term government bonds as a way of pushing downward their yield and thus reduce the yield-curve spread. But even such action may not be very successful in a world where such long rates depend as much as anything else on the global supply of savings relative to investment. Thus, even radical action such as outright Fed purchases of 10- or 30-year U.S. Treasury bonds may not work as much as desired.

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Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.

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