The Fed was created at the beginning of last century in an attempt, one that proved lacking during both financial crashes of the 1920s, to bring stability to a financial system prone to catastrophic collapse. Over the course of the late 19th century, bankers such as JP Morgan would step in during such panics and provide "liquidity," that is short-term infusion of money to get the system through the panic. However, the 1907 panic revealed the financial system too large for even Mr. Morgan to insure, so the Fed was created.
Providing liquidity in panics was one of the Fed's main reasons to exist. In this most recent panic, the Fed's slashing of interest rates and other measures to provide "liquidity" were completely in its jurisdiction. However, the Fed and Treasury took many unprecedented moves providing more than "liquidity," they attempted to massively shore-up solvency. An easy difference to understand a "liquidity" problem and a solvency crisis is that with liquidity problems a little money lent over a short period can get you back on track. Insolvency means it doesn't matter how much time and money I give you, you're not going to be financially viable, if at all, without taking significant losses.
There's been various measures the Fed and Treasury have taken to try and provide solvency including the Fed's balance sheet, government agencies stepping into buy loads of bad paper, and what may be most important, simply allowing the banks not to account their losses. That is simply pretending, but today Bloomberg(tx mish) has an important article stating,
"Banks will need to take “substantial” writedowns on home-equity loans to enable loan modifications that will allow the U.S. housing market to recover, according to Amherst Securities Group LP."So, despite all efforts by the Fed and Treasury, the banking system remains insolvent, held together by a boatload of government money and a continued officially sanctioned belief that future growth will eventually make all the bad numbers good. But the banks understand their financial predicament and this is why they refuse to lend money.
The "financial innovation" of the last three decades failed spectacularly. You'd be hard pressed to figure that out listening to anything out of New York and DC. The idea that securitization and derivatives made finance more stable was proved spectacularly wrong. The only person close to any officialdom saying this is Paul Volcker, who yesterday in the WSJ stated,
I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of?...Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.Not only did "financial innovation" not add a shred of growth, it made the financial system more unstable than it's been for seventy-years. The financial innovations and the Fed and Treasury's responses have made the system more unstable, specifically in two ways. First, it has greatly distorted the pricing mechanisms across the economy. It is very difficult from housing, to energy, to commodities, and currencies to understand if prices have any correlation to the "real economy" -- the financial system is broken.
Secondly and more importantly, the Fed and Treasury created not a new bubble, but a surrealistic version of the last one in which global currency markets are now in the middle. The instability of the global currency system has risen to a point not seen since the 1930s.
Next: The Dali Currency Bubble
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