August 22, 2007

The Fed's Dilemma: The Moral Hazard

So the Fed has an interesting problem: whatever it does-- raise rates, cut rates, etc-- it causes a Moral Hazard, but to different people.  To whom does it want to teach the wrong lesson?

Or, choose: rich get decimated, poor get poorer; or rich get richer, poor get by? 

This is part 3-- click for Parts 1 and 2


So the Moral Hazard for the Fed is that by cutting rates, it lets the hedge funds know that they will always be bailed out, that losses will always be contained.  So go ahead, take more risks.

If that was all there was to it, the story would be boring.  But there’s more.

Let me state explicitly that the mess we’re in is exclusively due to too much, too easy, credit.  In order to have prevented this, rates should have been higher, but to raise them now—when no one can pay anything back—would be death.  So rates either must at least remain the same, or get cut.

Here's the problem: 

If they don't cut rates, many lose their homes; some hedge funds go under; some franchises, that borrowed money to open their stores, go under; people lose their jobs; so there's less money in the system, and we get a recession.  Divorce inevitably follows.  But note clearly that while everyone loses in this scenario, the poor get hurt much more than the rich do.  (This is why it is a political certainty that they will cut rates, at least four times, before Nov. 2008.)

If the Fed cuts rates, we get a bailout-- people keep their homes, hedge funds don't go under-- but the the rich get richer while the poor simply don't get poorer.  Even the thought of rate cuts has pushed the prices of most stocks back to the levels they were before the correction.  They will only go higher from here.  In fact, the Moral Hazard here is that hedge funds learn that they'll always get a bailout, so they take even greater risks for greater profits. But your house doesn't increase in value, it just doesn't melt in the snow.  Asset prices and profits increase; wages don't.  The gap between rich and poor expands.

This is complicated by a point so obvious that it is never mentioned: rich and poor are experiencing two entirely different economies-- one with inflation, and the other in recession.

Here's an example of this wealth gap. One metric the Fed used to measure inflaiton is the Consumer Price Index, which is an aggregate of prices across sectors: food, energy, clothes, etc.  But in the past few years, the important metric has been the CPI omitting food and energy prices, because, supposedly, food and energy prices fluctuate wildly and thus are not stable enough to measure inflation.  Have you seen the price of oil for the past 6 years?  Does it look like its fluctuating wildly, or just staying high?  So whereas the CPI shows prices overall have risen, the CPI "ex food and energy" incorrectly shows prices relatively stable, because it omits the two main sectors that show inflation.

The rich don't "see" increased energy prices.  (Are their fewer SUVs on the road?)  They see credit tightening.   They see their asset prices falling.  They see "growth" declining.  That's recessionary. They want a rate cut. But if you get a rate cut, prices go up.

What do you do if you're poor, and you have less money, but prices are on the rise? You go see a psychiatrist, that's what. 

It's a tricky situation, so I'll summarize it here: prices have been rising, if you look at all prices.  So rates should have been higher.  Had they been higher, people-- everyone-- would not have borrowed so much, so poor wouldn't be seduced by low rate mortgages, and rich wouldn't have leveraged credit to bid up asset prices (including real estate.)

But at this second, everyone needs a rate cut, because everyone "sees" a serious deflationary pressure.  (If your biggest asset is your house, and its worth 3/4 what it was a year ago, that's deflationary.)  The result of this rate cut will be that the existing inflation, heretofore ignored by everyone, will be magnified.  So while the poor will not have more money (they'll simply not have less), the rich will get much richer.  Inflationary pressures will be much better handled by the rich, for obvious reasons.

And so the Moral Hazard. The Moral Hazard for the Fed is that by bailing us out-- and they will-- easy credit and the Bernanke put will worsen the cycle.  And so the Fed plays a game, a stupid game but what else can it do?  It orders rate cuts on key market days (options expirations) only days after it pretends it is worried about inflation; random Fed robots utter conflicting statements about the health or malaise of the economy-- all in an attempt to make it appear as though the inevitable rate cut is going to be canceled.  It's all about the Moral Hazard. 

But the game can backfire: if markets anticipate this is a game-- if they are sure there will be a rate cut, and they rise (Bank of America bought a stake in Countrywide, that's how sure of a bailout they are) then there's no need for a rate cut after all.   Which causes markets to fall...

But it's the wealth gap that we should be worried about, soon to be greatly increased.  Wealth gaps mean feudalism.  They mean, on the one hand, universal healthcare-- everyone gets the same; on the other hand, flow chart medicine-- since everyone gets the same, let's just make a flowchart. 

It also means mental health parity, which is really a way to funnel the poor into the only outlet we have to deal with their rage: psychiatry. 

(Part 4 tomorrow)

(Long BAC)