modulo the interest rate

we are in for some interesting times

I don't know how many people saw the Bank Limits Fund Access by Colleges article in the NY Times thursday

this is the sort of thing happening more frequently and triggering problems.

In this case a bank limited withdrawals on a fund invested in short term bonds, used by a large group of universities to roll over funding - these things are common, keeping a lot of cash in banks is a bad idea, but it has to be rolled over somewhere.

The problem is no that the debt has gone bad, but that the fund is no longer revolving since the bank can not manage it, so the investors have to wait for the investments to mature to get their money back - the funds are not liquid any more.
Further, the fund is liquidating, unless someone takes over its management soon, and will close and hand back the fund to the investors; so it won't be buying any more short term bonds, which means credit will crunch.
Oh, and in the short term institutions don't have the cash they need, so it doesn't get spent. In extreme cases, payrolls are not met.


The Paulson bailout is an attempt to break this loop, but sounds like it is too little, too late. Paulson seems at some point to have become convinced that what is good for Goldman Sachs is good for the US - he is concentrated on cleaning up the balance sheet on the surviving big investment bank players, not actually recapitalizing regional banks or keeping corporate credit going. It'd be nice to think that eventually the federal funds will trickly back down far enough to matter, but it may be too little, too slow and too much skimmed off to close off critical foreign investment, and of course maintain year end bonuses.

The long term cure of choice appears to have been chosen.
Bernanke is a theorist - he has a theory on how to avoid deflationary depressions like the Great Depression, without falling into a hyperinflation spiral.
The solution is moderate invention to reflate the economy, enough to catch nominal asset prices up again - maybe 20-50% price inflation over several years.
The catch is to avoid a tightening wage-price spiral, but wages have to ratchet up also, because otherwise the underlying cause persists, that people actually earning median income can not afford to pay for assets like houses. So wages must go up, but corporate interests are resisting that side of the turn because they want to recover corporate profits, not increase payroll costs. Which works microeconomically, but on the macro scale the question becomes who then are the customers?

Now, rationally, in a deflation people ought to accept negative interest rates, as long as deflation rate is more negative. This has almost happened, effective treasury rates for some short term bonds have been formally borderline negative as people seek to protect capital and forego even nominal gain.
But, in practise this does not continue, in deflation interest rates can go back up, as they do under inflation, because they become risk driven. Default rates go up, so interest rates go up, to protect against losses on defaults. The interest rate bounces as it heads to zero, it doesn't usually cross.
There's a nasty feedback loop there.

'course I'm not an economist, and I am sure the treasury boys have it all figured out.


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Now, rationally, in a deflation people ought to accept negative interest rates, as long as deflation rate is more negative.

What's rational about taking a negative interest rate when you can bury it in the backyard for a higher interest rate?

A nominal negative rate might make some sense as essentially a security fee. In fact, that's how I've heard the nominal negative Treasury rate explained. But more than a few bp negative is hard to fathom.

By Andrew Foland (not verified) on 05 Oct 2008 #permalink

a rational investor ought to only care about the spread, or the real rate of return

holding cash is a zero rate of return, but, it has some risk, and the risk is typically a probability of losing all the cash - if you can quantify that probability, then you know how much negative interest would be rational to accept rather than hold cash, in a deflationary environment

I think in the seventies for a while swiss banks offered effective negative interest on some accounts - they had low nominal positive interest but fees that were larger than the interest so effective return was negative
but perceived risk of loss of capital was very very low