Friday, September 19, 2008

How the Fed/Treasury Are Rebalancing Global Portfolios

A question I sometimes ask my intro macro students is, could the Fed, if it wished, conduct open market operations by buying (and later perhaps selling) famous paintings, rock memorabilia, etc.? This tests their understanding of the concept: any asset can be used to inject or absorb liquidity. Little did I suspect that the asset in question might be vast swaths of suburban tract housing. But the recent announcement that the Fed’s acquisition of junk mortgages would be partly financed by $100B in new Treasury issues indicates that the bailout is being insulated as far as possible from monetary policy.

But this is interesting from the standpoint of global capital flows too. Many of the investments of the last few years, like Chinese purchases of Fannie and Freddie stuff and Gulf capitalizations of US banks and shadow banks, aren’t looking very good right now. All indications, in fact, are that sovereign funds are rebalancing as fast as they can away from anything that bears the slightest whiff of the US housing market. But where can they go and still stay in dollars? Answer: the Fed can buy up the tainted assets our creditors no longer want to hold, financed by new Treasury bonds, financed by these same creditors. The creditors are happy (or at least placated) by being able to shift away from risk, the capital inflows needed to finance the US external deficit keep flowing, and enough domestic credit market players are refloated to keep the debt game going a while longer. In theory the Fed/Treasury risk laundering scheme could be extended to new classes of debt, like consumer credit and corporate paper, as their quality deteriorates. The longer it continues, the longer US employment and income can be buoyed up by borrowing, giving the macroeconomy a semblance of stability. I’m getting the feeling, however, that this is an endgame scenario, not a new financial equilibrium.

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