Problems of Fed’s Commercial Paper Program

November 6, 2008

Let me first say that I am an economical pragmatist, and that I subscribe to no ideology. I believe that government intervention, and even state corporatism can have a role to play in certain circumstances, but I also believe that a nation should always aspire to be as free as possible, culturally, politically, and economically, simply because an efficient dictatorship is always harder to create. In general, people know and do their own business better, and survival and prosperity are the business of all human beings, wherever they live, whatever tongue they speak.


In this context, I’d like to emphasise that I have no grudge against the government, and even sympathise with their difficult situation. There’s no question, in my mind at least, that Mr. Paulson is a respectable and decent individual, that Mr. Bernanke is a brilliant economist, and that both of them have the best intentions in this very severe crisis.


But truth must be spoken. There’s a lot to be criticized about their actions, but time is limited, so I’ll only deal with the CPFF, and what it is doing for the economy, in this post, briefly, but hopefully also succinctly.


Now, we have recently seen the Fed intervening in the commercial paper market, and buying practically unlimited amounts of all sorts of CP (commercial paper), in accordance with the belief that panic in markets is causing an illogical and unjustifiable contraction in issuance. Numbers released by them show the commercial paper outstandings expanding in the last week, as the impact of the heavy hand of the government hits the market.


Let us consider this graphic, which shows data as of November 5th.






It  shows outstandings, that is, the total amount of commercial paper, in different categories. What do we see here? First of all, the yellow line, which shows asset-backed commercial paper including suprime and alt-A mortgage backed paper, has been collapsing since August 2007, and its precipitous contraction was the starting bell of this crisis. The red line shows financial commercial paper, which includes paper issued by investment banks, and others, and which rang the bells for the second, panic phase of this crisis in September, with the collapse of Lehman. The third, blue line shows the issuance of non-financial corporations, like automotive firms or computer manufacturers, in other words, it shows the real economy.


What do we notice here? And what do we discern with respect to Federal policy?


In a sense, this is a typical graphic which demonstrates increased correlation  across asset classes and convergence of risk perception for different classes financial assets. We see clearly how the panic of last year has been spreading across sectors of the economy, causing financial actors to treat all counterparties in a single category of risk, and eventually inhibiting activity, and preventing ever larger parts of the economy from functioning. We also see that the changes in attitude do not occur gradually, but with leaps and bounds. In other words, people often refuse to adjust their positions to account for changes in economical data and risk perception, but rather choose to be crushed by the data, following the stampeding crowd once panic forces everyone to adjust, regardless of whether they believe or understand the changes or not.


So much for the efficient market hypothesis…


And what does it tell us further about Fed policy, how efficient, prudent, or meaningful it is?


First of all, a careful analysis of the data shows that the recent rapid correction in outstandings of commercial paper should not be unwelcome. The graphic clearly shows that there was an enormous bubble in financial CP outstandings in the period of 2003- 2008, and ABCP issuance in the period 2004-2007. The burst of this bubble, and the subsequent contraction in issuance is not only natural, but it is also entirely natural, and should be welcomed by every prudent regulator. There was never any financial discovery, any economical development in the US in these periods to justify the massive expansion in commercial paper issuance. The financial sector had overexpanded by speculative activity in an easy money environment, and as it, so does it’s issuance of commericial paper.


If this is the case, what is the Federal Reserve gaining by inflating a market which, due to the most basic tenets of free market principles, should contract? What is the Federal Reserve achieving by irrationally sustaining a market which has been exceedingly overextended in the past years, and only has to contract so that it readjust and reform itself?


Of course the Fed is gaining nothing, and by trying to inflate a market, which should and undoubtedly will contract in the future,  is only throwing public money away into the gutter. What the experience of the Stock market bubble, and the housing bubble of the last ten years has thought us is that it is not possible to contain or prevent the bursting of a bubble. Attempts directed to toward sustaining a bubble are usually counterproductive, and eventually increase the severity of the crisis, rather than easing it.


The Fed justifies its actions by citing the blue line in the graphic, and the massive rise in spreads in the period that led to its interventions. While it is true that some intervention was necessary, the swooping scoop method that the Fed has used is so indiscriminate about what it saves that it will, in the end, almost undoubtedly cause much harm to the economy, and will probably prolong the healing process, if it at all works, and I don’t think it will. We will see more collapses and more panic in the coming weeks. It will last until some firms are allowed to go bankrupt.    


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