Is it the role of Central Banks to help us avoid another Depression? Reserve Bank Governor Rick Battelino has penned what you may as well call “The Depression for Dummies”. In a speech before the Retail Financial Services Forum yesterday, Mr. Battelino first explained how central banks conduct open market operations to keep the price of money near their target levels. Though we weren’t there, we’re sure it was scintillating.
He did not, from the transcript we found at the Reserve Bank’s website opine on why there is no free market for money in a so-called free market system. That would have been an interesting discussion. Gold would have come up. Gold has been a medium of exchange for much longer than the paper you carry around in your wallet.
No. Governments and those with the monopoly on the money supply don’t like to discuss why there’s no free market for money. You don’t have to be a gold bug to enjoy that discussion, though. Should there be a free market in money?
One theory of the Great Depression is that global money supply did not grow quickly enough to accommodate the increase in global productivity. True? False? Who knows? But it’s a worthy question…how does the money supply grow to accommodate new goods and services in a free market for money? Feel free to send in your ideas to email@example.com or leave a comment at the end of this post.
Governor Battelino had his mind on more practical matters, like whether the American-born subprime credit crunch has affected Australia financial institutions. It has, he admitted.
He explained how the whole thing started with investor losses from securities with subprime loans from the US housing market as collateral. He said that “While the losses incurred in some cases have been severe, these problems for quite some time did not seem to have any significant ramifications more generally through the financial system.”
“That changed on 9 August, after a large European bank announced that it was freezing withdrawals from three of its investment funds due to losses incurred by those funds and the difficulty in valuing their security holdings.” Hold the phone. That was the day investors realised there might be a lot more risk in the financial system than they’d been told by the so-called authorities.
Mr. Battlelino said, “Investors became much more risk averse and banks severely curtailed their lending to each other, causing gridlock in the money market. The process spread quickly because once banks started to worry that others may stop lending to them, they in turn stopped lending to others.”
We wouldn’t expect bankers to trust each other anyway. Nobody else trusts them. But it IS the business of banks to lend to one another. And when they stop doing that out of a general distrust of each other, the financial system has reached a serious impasse. You might even use the word crisis. Central bank actors to the rescue!
“The Reserve Bank,” Mr. Battelino said “decided to supply more than the usual $700-800 million of exchange settlement funds, so that the overnight interest rate would not rise above the target set by the Board in early August. Those operations were successful in maintaining the cash rate at the 6.5 per cent target, though other short term market interest rates remained unusually elevated. Since then, the (RBA) has continued to supply whatever amounts of exchange settlement balances were necessary to keep the cash rate at the target.”
Let’s summarise: some hedge funds lose money when they realise their assets are not worth the paper they’re printed on. Investors in those funds politely ask for their money back. That request is denied. Loss of trust ensues. Loss of trust spreads to banks, no longer willing to lend to one another.
Another way of putting it is that the loss of trust and the diminishing value of assets backed by debt led directly to a dramatic increase in the price of money. If the market could speak, that’s what it would say. Prices are the language of the market. We should listen to them more often instead of manipulating them.
Central banks did not like what they were hearing from the market. You might argue the market itself had stopped working, and the CBs revived it with an infusion of credit. But the market didn’t stop working. It’s just the market price for the collateral the investment banks wanted to sell was so low (zero), that they cried uncle.
In stepped the Nanny State bankers to artificially lower the price of money by making more of it available. They bailed out the investment banks and calmed nerves, saying, “Look children…there’s plenty of cash. You mustn’t hoard it. Don’t worry if you lose it. We’ll make more!”
The market has spoken though, loud and clear. Right now, it’s more of a whisper. But if you bend down close and cup your ear you can hear it.
Here’s what it’s saying: “You can’t get rich spending more than you make, or consuming more than you produce. Excess credit leads to irresponsible and even immoral behaviour. If you save and invest, you create tomorrow’s incomes and future prosperity. If you borrow and consume you will only destroy yourself.”
The market might not actually say all that. It might just separate you from your money. There’s a lot of that going on right now, in fact. It’s probably just the beginning.
Markets and Money