The new War to Save Credit

The idea didn't work in Japan because a persistent recession had gutted demand for money, and, besides, banks didn't think it wise to lend to failing companies. Economists call this a liquidity trap: When expected returns are low, investment falls, so economic activity slows. Then cash holdings rise because people expect returns to fall -- which, of course, they do. Ergo, it's a trap.

The Fed has tried to bust the U.S. economy out of this trap first by embarking on a path to cutting rates to zero by early 2009, then by increasing the size of its balance sheet through the printing press, then by changing the composition of its balance sheet by buying agency debt to keep yields down. Since none of this has jump-started the economy, the Fed has gone on to buying bank securities directly, taking over the role of private fund managers in a process economists call intermediation.

All gas, no mileage

If you step back and try to understand why this is happening, it all goes back to our old subject: deleveraging. In the past decade, the securitization of mortgages and other loans into asset-backed bonds -- and then the repackaging of those bonds into superleveraged collateralized debt obligations -- sped up the velocity of money to an unprecedented degree. Through securitization and borrowing, $1 became $30 pretty quickly via some investment banker's sleight of hand. But the securitization market is now dead amid a collapse of funding and confidence, and with it has gone the old velocity of money that had kept companies and individuals borrowing at a frenetic pace.

So all the Fed efforts now are basically aimed at revving money velocity back up -- and so far the ol' girl just won't go, largely because confidence that it makes sense is low. As one fund manager, who declined to be identified, told me in an interview this week: "We keep trying to find a silver bullet instead of just allowing deleveraging to run its course. Now that bullet is getting more and more expensive, and also requires so much gunpowder that it might destroy the gun."

Shoveling cash at undeserving banks is just what you would expect from bureaucrats who didn't have to earn that money in the first place -- and who will be out of office before the plan blows up. Moreover, authorities who have studied Japan's lost decade complain that cash-bombing the financial system will delay structural reforms and introduce dangerous market distortions.

An example: All the money that the Fed is throwing at the credit markets isn't real, at least not yet. It is being printed now on the expectation that America will be able to borrow it in the future by selling new bonds, much like a family that buys a bigger house than it can afford on the expectation that Dad will get a raise. If the Fed can't raise the money from investors -- that is, if the raise doesn't come through -- the risk of default rises.

This plan works as long as our creditors, primarily China and Japan, keep recycling their savings into U.S. paper, as they have for decades. But if they pull back from financing the U.S. debt binge even a little -- and there are signs they will -- the strategy will unravel, led by a devastating downgrade of America's sovereign debt rating and a train wreck for the dollar.

For a sign that key Asian fund managers are already starting to thumb their noses at the United States, just look at their reaction to the sale of $17 billion in government-guaranteed bank bonds as part of the new Federal Deposit Insurance Corp. liquidity program. The new three-year bonds, which yield around 3.3%, or 2 percentage points more than comparable Treasury bills, were bought Nov. 25 by 347 institutional investors -- 70% of them from the U.S., 20% European and just 10% Asian. The snub stunned credit market observers because in the past Chinese and Japanese investors had been avid buyers of agency-backed debt.

This is why we need to stop confusing activity with achievement. Without massive overseas support for its planned new borrowing, the Fed's efforts will take only "tail risk" -- i.e., depression -- off the table, but not a lot more.

Meet Markman at The World Money Show

MSN Money's Jon Markman will be among more than 100 investment and finance experts sharing their advice on what to buy and sell in 2009 at The World Money Show in Orlando, Fla., Feb. 4-7. Invest four days dedicated to planning and refining your portfolio by attending some of the event's more than 300 workshops and panel presentations.

Admission is free for MSN Money readers. To sign up, call 1-800-970-4355 and mention priority code No. 012660, or register online.

At the time of publication, Jon Markman did not own or control shares of any company mentioned in this column.

< previous |  1 | 2 |