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Tuesday, 17 March 2009

The Danger of Over-Inflating While Underwater

A scuba instructor once told me the tragic story of a diver who tried to salvage an outboard motor at the bottom of a lake. Struggling to raise the motor, our man decided to fully inflate his buoyancy jacket for extra lift. All went well until he lost his grip on the motor, transforming himself into the human version of a Polaris missile. A fatal case of the bends ensued.

Of course, Messrs Bernanke, King et al. are also struggling manfully to lift something heavy that is deep underwater. For extra lift, they are also pumping lots and lots of air into the economic buoyancy control devices, and even appearing on TV to talk things up. The obvious concerns are (a) the amount of air being pumped in, (b) when to stop pumping and (c) how fast they can get the air out again when the economy turns to prevent it going ballistic.

The AIG saga seems instructive on this last concern. The $170bn in government aid is said to have been used to boost the "collateral" (or reserves) that secured AIG's insurance obligations on dodgy credit-default swaps (CDS's). And about $105bn has since been paid out to insured banks (on the full face value of the CDS's - hey presto, no loss!). In turn, the banks have used the money to shore up their own "reserves" rather than lend it - much as they're doing with the bailout money they receive directly, more of which is being printed as we speak.

There is no single definition of the term "reserves". To a large extent, what's prudent or required today may be deemed overkill next quarter and released to revenue and used in the ordinary course again. Given the care they took on the way into this mess, my bet is that as the economy turns the banks and insurers will release the reserves and provisions they made in a panic over the lack of liquidity way too quickly for central bankers to get the surplus air out of the economic buoyancy jacket. See picture for the consequences...

That's not to say there's any practicable solution at the global level, or that individually any of those banks or insurers will be wrong to release the reserves in question. It's just the system we have. It ain't perfect, as Lord Turner has just explained [stable door creaks and slams shut].

So, on a personal basis, one might at least consider that a tracker mortgage with an interest rate cap, or even a fixed rate mortgage, is a prudent option right now.

PS: Earlier in May, I went with a fixed rate mortgage, as the tracker with cap options started getting too expensive at the level of the cap.

PS: 28 May '09, FT Alphaville notes: "Wednesday saw a frantic steepening of the Treasuries curve... The fact is there is a growing perception in the market that further down the line, a messy quantitative easing-exit strategy might see the Fed forced to raise rates quite fiercely." I guess John Kay would say there is an opportunity to bet against the market, here. However, perception seems to be everything, so if the Fed is persuaded the market is looking for a rate hike, it may well deliver, and other central banks may have no alternative but to follow.

PPS: 10 June 09: Interactive Investor summarises the "flamewar" between Keynesian and Monetarist economists over the implications of rising bond yields.

Let's hear this post from Merv King himself:

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