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Liquidity Rest Stop or Toxic Waste Dump? February 19, 2008

Posted by davidzweig in economics, financial crisis.
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The economics blogosphere has been atwitter the past week with speculation about the anomalous rise in something called H.3 at the Federal Reserve. H3., about which almost none of us new or cared until recently (and now about which almost none of us know but most of us should care) is a measure of the volume of cash that banks are required to keep on deposit at the Federal Reserve. There this money stays (interest-free) for a stormy day, such as happened here in 1929, or in 2007 in London, when frightened investors ran on banks.

The graph, reproduced above, shows the recent precipitous drop in non-borrowed reserves. What caused it? Late last year, to loosen the frozen gears of liquidity, the Federal Reserve liberalized the types of collateral that banks could pledge in order to borrow directly from the central bank. The interest rate for this temporary “Term Auction Facility” is lower than the target federal funds rate, so naturally banks are going there in droves.

Crisis averted? Not so fast.

The Financial Times of February 18 lead with an article by the redoubtable Gillian Tett:

US officials say the trend shows that financial authorities have become far more adept at channelling liquidity into the banking system to alleviate financial stress, after failing to calm money markets last year.

However, the move has sparked unease among some analysts about the stress developing in opaque corners of the US banking system and the banks’ growing reliance on indirect forms of government support.

“The TAF . . . allows the banks to borrow money against all sort of dodgy collateral,” says Christopher Wood, analyst at CLSA. “The banks are increasingly giving the Fed the garbage collateral nobody else wants to take . . . [this] suggests a perilous condition for America’s banking system.”

“Dodgy” is a favorite Anglicism. It is seldom used on this side of the Atlantic, but we have so much that is worthy of the appellation. It means “evasive, suspect, shifty” or “flimsy and insubstantial.” We really need to use the word more because we lack a substitute….

To the point: if Christopher Wood is correct, then we are seeing two laws of physics contradicted:

  1. (Toxic) matter can be created but not destroyed
  2. Said toxic matter can flow uphill.

Garbage in. Money out.

It is appalling to see yesterday’s Ayn Rand acolytes now on their hind legs begging for bailouts. It’s almost as bad to see them passing such detritus back to the Fed, if Mr. Wood is correct.

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