The near collapse of Long-Term Capital Management LP and the rush of central bankers and leading financial institutions to save it speaks volumes, not only of the new nature of the U.S. and world economies, but also of the urgent need for concerted action to forestall a global recession.
Our monetary system has been rapidly transformed over the last half century, a period that coincides with the brief, illustrious history of hedge funds.
Back in the 1950s and '60s, commercial banks performed the primary economic function of intermediation, that is taking money from savers and placing it into productive uses. The banks did this by paying passbook rates of some 3% and then intermediating the deposits by lending them to businesses, homeowners and commercial real estate projects. That was a simpler time, when the United States had a higher savings rate and savers were either captive or more complacent.
In 1998's world of trade deficits and imported capital, the marginal saver in the U.S. monetary system is foreign. Japanese banks have backed down from their intermediary role. As a result, low-risk foreign savers now buy U.S. Treasury notes and bonds with their dollar savings rather than make bank deposits in their own countries.
In the absence of banks, hedge funds such as Long-Term Capital and Wall Street dealer firms have become the intermediaries in our monetary system -- but not in the way banks traditionally performed this role. These new intermediaries have typically sold short U.S. Treasury debt and used the proceeds to buy home mortgage securities, commercial mortgage-backed securities and corporate bonds. In essence, Treasury securities have become the bank deposit in today's financial system.
But there's a problem with this new system of intermediation. While the United States had been issuing new Treasury securities at an unprecedented rate for almost 20 years, those new issues stopped abruptly this year, and caused an unintended consequence of the federal budget surplus. The surplus, by taking away the flow of new Treasuries, took away the "bank deposits" that enabled credit intermediation.
Accompanying the budget surplus is the flight to quality in the world's financial markets. In this environment, demand for U.S. Treasury securities continues to escalate. As a result, we have had a short squeeze on Treasury securities as hedge funds and dealers cover their shorts. This short squeeze could develop into a "buy and hoard" mentality as holders of Treasury securities become more reluctant to sell them. The more Treasury securities rally in price, the more Treasury holders become afraid of financial collapse. Meanwhile, the rise in Treasuries' prices convinces holders they have made a wise investment decision. Motivated by fear, they are not about to sell. Conversely, the more prices rise, the more desperate short sellers become who want, or in some cases have, to buy.
With prices for Treasuries high, yield spreads on corporates and mortgage securities have widened significantly vs. Treasury securities of late, and on many days recently, when there have been few, if any, buyers. Consequently, mortgage finance and bond finance (and stock initial public offerings, too) have effectively come to a halt, and investors holding corporate and mortgage securities have endured sharp losses. Predictably, in an environment of declining corporate earnings and low domestic savings rates, without finance, capital spending is going to drop. And not drop to 5% or 6% from its double-digit growth rate of recent years, but actually decline. The result? A significant decline in world trade and economic activity. In a word, recession.
There are immediate ways to address this scenario:
* Further Federal Reserve policy ease. This means making the yield curve steep enough to motivate U.S. commercial banks to become the intermediaries of foreign credit again. At today's level and shape of the U.S. yield curve, the market is suggesting we need a federal funds rate below 4%. Two cuts in the federal funds rate by the Fed of 1/4-point each since Sept. 29 are certainly steps in the right direction. But will they be enough?
* Significant, immediate tax cuts and/or increased federal spending to eliminate the federal surplus.
A longer-term remedy:
* Social Security obligation bonds, similar to pension obligation bonds sold by some states. The U.S. government could sell Treasury securities and invest proceeds in the private sector to fund future Social Security payments.
Someone had better act because markets are moving to reflect this new economic reality. Long-Term Capital is just the start on a path to a lower standard of living, as market forces slow capital spending and cause a world trade decline and recession.