A month ago when I spoke to a potential financial tsunami, it was not to bail out our position of already well protected Agency mortgage-backed bonds. It was to alert you and yes, policymakers, that this inherent instability in our capitalistic system was threatening to feed on itself first in the housing market and then spreading to financial institutions – banks, investment banks and insurance companies as the sale of assets in the process of delevering led to home foreclosures and then bankruptcies for weak institutions that held assets of all kinds. That was not, I think, an inaccurate assessment as recent events have proven. But importantly, because prices are going down in every asset class, the threat to future investment in long-term capital projects and the real economy becomes magnified. That doesn’t mean of course that capitalist investors must be guaranteed a profit. Far from it. But when prices in all asset categories decline by double-digits, well then Washington, London, Frankfurt, Tokyo, and Beijing – we have a problem. I reproduce last month’s asset price chart to accentuate my point.Now, as recognition of a systemic period of capitalistic instability becomes apparent, the focus has legitimately shifted to a systemic solution. Much of the focus has been on U.S. policy and rightly so. It is here where the excesses of exuberance were most pronounced. But, up until the Treasury’s $850 billion rescue package, the policy responses may have been necessary and significant, but they were ad hoc and perhaps insufficient. A systemic delevering likely requires a systemic solution, which moves beyond cyclical interest rate cuts, liquidity provisions, or even the purchase of subprime mortgage-backed bonds. We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive) their Big Macs at the second window. They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.
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