Paul Krugman discusses the potential for problems due to the evaporation of liquidity from financial markets over the last few days:
Very Scary Things, by Paul Krugman, Commentary, NY Times: In September 1998, the collapse of Long Term Capital Management, a giant hedge fund, led to a meltdown in the financial markets similar, in some ways, to what’s happening now. ... The Fed coordinated a rescue..., while Robert Rubin, the Treasury secretary..., and Alan Greenspan,... the Fed chairman, assured investors that everything would be all right. And the panic subsided...
What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in ... financial instruments backed by home mortgages ... have shut down because there are no buyers.
This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.
The origins of the current crunch lie in the financial follies of the last few years... The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.
Everyone knows now about the explosion in subprime loans ... and the eagerness with which investors bought securities backed by these loans. But investors also snapped up ... junk bonds, driving the spread between junk bond yields and U.S. Treasuries down to record lows.
Then reality hit... First, the housing bubble popped. Then subprime melted down. Then there was a surge in investor nervousness about junk bonds...
Investors were rattled recently when the subprime meltdown caused the collapse of two hedge funds operated by Bear Stearns... Since then, markets have been manic-depressive, with triple-digit gains or losses in the Dow ... the rule rather than the exception for the past two weeks.
But yesterday’s announcement by BNP Paribas, a large French bank, that it was suspending ... three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of “the complete evaporation of liquidity in certain market segments” — that is, there are no buyers.
When liquidity dries up ... it can produce a chain reaction of defaults. Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C...
And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them.
The Fed normally responds to economic problems by cutting interest rates... It can also lend money to banks that are short of cash: yesterday the European Central Bank ... lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.
But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much ... if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults.
There are other, more exotic things the Fed and, more important, the executive branch of the U.S. government could do to contain the crisis if the standard policies don’t work. But for a variety of reasons, not least the current administration’s record of incompetence, we’d really rather not go there.
Let’s hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn’t count on it.