John Maynard Keynes is the man of the moment. His ideas of ‘spending your way out of a recession’, which were left by the wayside in the ‘70s, are now a must have to keep next to your Charlie’s Angels pillow case and your Sergeant Pepper album sleeve. In the last month we’ve seen bailout after bailout. TARP, TAF, CPFF … the US alone has 6 different bailout facilities. Seems Paulson will run out of letters before he runs out of cash! However perhaps more important than these was a bailout of a different kind – the co-ordinated interest rate cuts of October 8th which we may even see repeated this week.

These actions by the various governments have been just about the only good news in the recent financial Armageddon, so perhaps it is not surprising that these plans seem to have been almost universally welcomed by the media. What criticism there has been has tended to focus on details of the plans. And of course more rate cuts are expected today and next week. But no-one seems to be answering the big question – are bailouts and interest rate cuts the way to go? Or would the free market, if left to its own devices, do a better job of cleaning up this mess?

The Problem Of De-leveraging
Let’s start off with the central problem – that of “de-leveraging”. A lot of banks, brokers and hedge funds spent the last few years finding new ways to increase their leverage (i.e. borrowing more money and invest it). Leveraging, as most spread bettors know, increases the size of both your profits and your losses. So, with market conditions the way they are, the majority of institutions now want to reduce their leverage and so reduce their risk. And this means selling assets.

There is, however, a problem. Let’s take a simple example and say you run a small fictional Hedge Fund whose balance sheet shows $30 million of it’s own assets and $300 million of assets purchased on credit (i.e. with borrowed money). During the boom years of 2003 – 2007 this model made you a lot of money. However in 2008 your broker wants you to reduce the amount of credit and charge you more for the remaining credit.

There’s clearly only one thing to do; sell some assets and repay the broker. Initially this may work – you may be able to sell $30 million of assets. Your balance sheet now shows $30 million of your own assets and $270 million of borrowed money However if all the hedge funds and other ‘levered’ investors are trying to sell and if there are few buyers then prices will fall rapidly. So the next time you try to sell the assets you find the asset price has fallen – allowing you to repay less debt. And the more you and your colleagues try to sell, the less money you recover and the worse the problem gets.

The falling prices will, of course, also have an effect on the assets you bought with your own money. So what your broker will see is the original $30 million of your assets, which provided them with some safety, shrinking fast. Hence they’ll want you to reduce your credit even further. And so they cycle continues

Government Action
According to Keynesianists (yes, that’s what they really are called), the solution to this vicious circle is to have massive government intervention – which is exactly what we’ve seen. The interventions so far have followed three paths:

• a ‘vacuuming up’ of the assets being sold. In theory this allows the financial institutions to sell without the prices collapsing – and thus successfully de-lever.
• injecting capital into banks, presumably in the hopes that if they feel secure they’ll be more likely to lend on favourable terms.
• lowering interest rates, again presumably on the assumption that these rate cuts will eventually make their way through the system and be passed on to end consumers. Another US rate cut is expected today

Is It Working?
The US has been trying to spend its way out of a looming recession for the best part of a year now, and so far it hasn’t worked. First we had Bush’s $100bn plus tax rebate cheques. Impact: negligible. Then we had the US bailout mark I, passed by Congress on October 3rd and followed by co-ordinated interest rate cuts from 5 central banks on October 8th. Since then the Dow has dropped 25% and various capital injections into European banks have similarly failed to stop the slide in European markets. Now most people are expecting a second bailout in the US and a second set of interest rate cuts this week.

One of the issues is that, no matter how much money you inject and how low you drop rates, you can’t actually force banks to lend if they don’t want to. And indications are that they don’t. The following is extracted from a recent New York Times article:

“Chase recently received $25 billion in federal funding. What effect will that have on the business side and will it change our strategic lending policy?”

It was Oct. 17, just four days after JPMorgan Chase’s chief executive, Jamie Dimon, agreed to take a $25 billion capital injection courtesy of the United States government, when a JPMorgan employee asked that question.

“Twenty-five billion dollars is obviously going to help the folks who are struggling more than Chase,” Dimon began. “What we do think it will help us do is perhaps be a little bit more active on the acquisition side or opportunistic side for some banks who are still struggling. And I would not assume that we are done on the acquisition side just because of the Washington Mutual and Bear Stearns mergers. I think there are going to be some great opportunities for us to grow in this environment, and I think we have an opportunity to use that $25 billion in that way and obviously depending on whether recession turns into depression or what happens in the future, you know, we have that as a backstop.”

Read that answer as many times as you want — you are not going to find a single word in there about making loans to help the American economy.

John Thain, chief exec of Merrill Lynch, was even more direct. This quote again comes from the New York Times.

“We will have the opportunity to redeploy that,” Mr. Thain said of the new capital on a telephone call with analysts. “But at least for the next quarter, it’s just going to be a cushion.”

The problem here is that it is simply not in banks’ interests to lend – not when the future is so uncertain. If banking losses continue at their current rates the banks are going to need every cent they can get. No amount of interest rate cuts or cash injections will convince them to start taking risks again. And, in the US at least, why should they when the US government is now lending to corporations at rates the banks can only dream of.

Good Credit And Bad Credit
Want another reason why the current approach might not work? Have a look at this blog on bank lending – well written and well worth 5 minutes.

However if you don’t have 5 minutes the author reminds us that bank are meant to facilitate the transfer of capital from savers to lenders. Hence a bank pays interest on deposits, receives interest on loans and makes a profit on the difference between the two rates. And the rates are set by the supply and demand of savings and loans.

All works well as long as a bank does not try to loan out more than it has in deposits (or at least not too much more). However when a bank starts lending out money for which there is no deposits (e.g. money that has been provided by a central bank) at interest rates that are being held artificially low, trouble starts.

The author argues that by leaving interest rates alone and not trying to force the banks to lend, unprofitable and unsustainable businesses will be flushed out of the system faster. What will emerge is a stronger and fitter economy. Give the article a read and see what you think.

And One Last Stab At Playing Devils’ Advocate
Most people do seem to agree on the causes that have got us into this crisis.

• Firstly US interest rates were held artificially low from 2001 onwards, in order to soften the blow from the dot-com bubble bursting. This had the die-effect of fuelling a housing bubble.
• Secondly the US consumer went crazy, spending more than they were earning.
• Thirdly and finally there were multiple levels of irresponsible lending, to individuals who should not have been granted a mortgage and from financial institutions of all types that were leveraging up to unsustainable levels.

So, could someone please remind me how cutting interest rates and twisting banks’ arms until they lend again is a good thing?