Central Banker Admits US Subprime Crunch Affecting Australia

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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 dr@dailyreckoning.com.au 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.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Glenn Stevens says we should not call the recent activities of the RBA a “bail-out”.

    If it were anyone but him, I’d go ahead and call it.

    Since we have so much affection for the cuddly li’l guy, how about using term “corporate dole”? Or even “bankers’ blankie”?

    “Today the Central Bank began devaluing the Aussie dollar in response to investors’ demands to refuse risk while accepting profit.” That has a nice, politically-correct wordiness to it too.

    Not as pithy as “bail-out”, but anything for Mr Stevens.

    Reply
  2. John Howard can you smell maxime Mckew breathing down your neck? Janet better start washing the bed sheets and setting the placemats for Mrs Rudd.

    dubious pete in melbourne
    August 28, 2007
    Reply
  3. Q:How does the money supply grow to accommodate new goods and services in a free market for money?

    A: It doesn’t.

    Given a relatively stable money supply (which free markets in money have always tended towards in the past: hard-money/gold/silver) the price of goods will decline when productivity increases.

    Reply
  4. Dan writes: “…the diminishing value of assets backed by debt …

    The word asset derives from asetz (1531 Anglo-Fr), in turn from assez meaning “enough” (O.Fr.) from Vulgate Latin meaning “to sufficiency”.

    As a legal word, a speaker of the word first meant “an estate sufficient to satisfy debts and legacies” and by 1583 meant any property that theoretically can be converted to ready money”.

    First of all, paper contracts are not assets if you cannot sell them for monetary face value. What you have is fancy wall paper.

    More importantly, debt cannot back anything, ever, as you claim.

    It’s the promise of cash flowing to obtain a steady income from renting cash that might make a paper contract have any monetary value.

    When that cash does not flow and no income gets obtained, the paper contract becomes worthless.

    Thirdly, shills like Robert Shiller claims “falling home prices encourages mortgage defaults.” [Bloomberg TV, 28-Aug-2007].

    Mortgage defaults happen because of a lack of cash flow — cash rentees simply have insufficient income both to pay to live and to repay rented cash.

    What many are missing from this “sub-prime” story is the bigger story of income implosion happening in the USA due to the equalization of global wage rates.

    Reply
  5. The Depression was caused by an excessive build-up of credit funding an asset bubble. The following dynamic was one of a self-reinforcing spiral of falling prices and bankruptcy. As prices fall, the real burden of existing debts increases. What this leads to is an intractable insolvency of the banks and many actors in the economy. Also, when prices are falling, especially in periods of high uncertainty, the velocity of money falls which further depresses aggregate demand.

    There is much more to the story but that is the most critical stuff. Money supply not growing quickly enough – nonsense.

    Reply
  6. Hello. If someone needs a bit of cash go to cashlot.co.uk/?5582.

    Reply

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