08-13-2007, 02:41 PM
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#1
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Lifetime Suspension
Join Date: Sep 2005
Location: The Void between Darkness and Light
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Paul Krugman is scared...
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What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in stuff that is normally traded all the time - in particular, financial instruments backed by home mortgages - have shut down because there are no buyers.
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Quote:
But yesterday’s announcement by BNP Paribas, a large French bank, that it was suspending the operations of three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of “the complete evaporation of liquidity in certain market segments” - that is, there are no buyers.
When liquidity dries up, as I said, it can produce a chain reaction of defaults. Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C - and those who do have cash sit on it, because they don’t trust anyone else to repay a loan, which makes things even worse.
And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them.
The Fed normally responds to economic problems by cutting interest rates - and as of yesterday morning the futures markets put the probability of a rate cut by the Fed before the end of next month at almost 100 percent. It can also lend money to banks that are short of cash: yesterday the European Central Bank, the Fed’s trans-Atlantic counterpart, lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.
But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults.
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linkypoo
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