Tuesday, December 23, 2008

Clever, maybe

Alistair Milne has an interesting comment over on the forum attached to Martin Wolf's column at the FT.  He wants to encourage the central banks to pursue a specific type of quantitative easing that will work better than the flavor Japan pursued.  The basic idea of quantitative easing is straightforward -- the central bank goes out and buys government securities from banks and private individuals and pays for these with freshly created reserves.  Theoretically, the banks should lend these new reserves to businesses, and the amount of money in circulation should increase, counteracting any deflationary tendency.  In the case of Japan, the problem was that the banks didn't lend the money out.  Alistair's solution:

Quantitative easing will be much more effective if the central bank uses its balance sheet to buy not government bonds but better quality illiquid and undervalued structured and mortgage-backed securities. This eases bank funding constraints and so directly expands the stock of credit. Moreover, as the economy recovers, credit spreads will fall and so the central bank can make a profit.

Quantitative easing will be more powerful still if the central bank takes pure credit spread exposures, using interest rate swaps to remove its exposure to fluctuations in nominal interest rates.

At first blush this makes great sense, and was the basic idea behind TARP -- buy up the iliquid securities so that bank balance sheets are cleaner and more liquid, which should reduce the amount of cash they need in reserve and encourage them to lend to businesses as well as ecourage businesses and investors to once again trust that the lenders are solvent.

Unfortunately this does nothing to answer the question of what you should pay for these things.  If the Fed or the BOE starts to directly target credit spreads by buying "better quality iliquid and undervalued" paper, it must be able to figure out what paper actually fits this description and what it's worth.  But if it were so obvious that these securities were undervalued, there would be private investors willing to buy them.  What makes him so sure that the Fed is so much smarter?  He goes on to argue that the Fed, being the creator of money, can meet and margin call, and so cannot be squeezed out of any trade.  True enough.  But is that why people aren't buying this paper?  Frankly I doubt it. 

All this talk about undervalued MBS takes for granted that the real problem is liquidity, and not solvency.  Probably some of this paper is undervalued.  I wouldn't doubt that.  A lot more of it is worth zero though.  If the Fed buys this worthless paper it is just continuing to subsidize an overly large financial sector.  That may keep credit spreads for real businesses low and (might) keep loans flowing, but it does nothing to fix address the most fundamental imbalance -- the financial sector needs to shrink relative to the size of the overall economy.

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