Rescuing Libor

The credit crunch started in the subprime market, but it seems that nowadays it's most visible, and most problematic, in the money market.

The contagion mechanism is the ABCP market: asset-backed commercial paper. ABCP came into existence to help quench a global thirst for liquidity; now that anything asset-backed is looked upon with suspicion, ABCP is untouchable and can't be rolled over. As a result, banks have to backstop their CP clients, which means that they need their money and don't want to lend it out. And interest rates in the overnight to one month end of the curve are almost a full percentage point higher than where one would expect them to be given the Fed funds rate.

Clearly, a large spread between Fed funds and Libor is not normal, and not in the slightest bit healthy. But is there a good policy response to this nasty gumming-up of the financial gears, and if so, what is it?

In the blue corner, we have David Gaffen and Yves Smith, saying that rate cuts won't help bring down the spread between Llibor and Fed funds. In the red corner, we have Brad DeLong and (strange bedfellow alert!) Larry Kudlow, saying that rate cuts are the only tool we've got right now, so we might at least try them to see if they work.

I'm generally sympathetic with the red corner: extra liquidity can breed confidence (although there's no guarantee it will), and right now I don't think that inflation pressures are so great that the Fed can't afford a rate cut.

On the other hand, Stein's Law says that if something cannot go on forever, it will stop – which means that somehow the financial system will get to a point where the spread between Fed funds and Libor will come back down to single digits. If that's true, then the Fed just decide to let the system work itself out, so long as credit-sector indigestion isn't about to devastate the real economy.

And then there's the question of how much the Fed should cut rates. DeLong writes:

We may indeed need a combination of fiscal stimulus and regulatory reform. But why not first push on the string? Maybe the string is rigid, and pushing on it will work.

But what happens if pushing on the string doesn't work? Do you give up, and decide it just isn't working, or do you conclude that you haven't pushed enough? Kudlow wants Fed funds "around 4 percent," which means that he'll continue calling for further cuts even if the Fed slashes by 100bp at the next meeting (which I very much doubt it'll do).

Ultimately, I'm on the rate-cutters' side. While the spread between Fed funds and Libor is important, the absolute level of Libor is if anything even more important. And that is certain to come down after a rate cut, even if the spread doesn't change at all.