Last week's stock market blowout added more than 4 per cent to the Dow Jones Industrials, but it had no affect on Libor rates. Libor rose steadily from Tuesday through Friday signaling more troubles in the banking system.

Libor, which means London Interbank-Offered Rate, is the rate that banks charge each other for loans. It has a dramatic effect on nearly every area of investment. When the rate soars, as it did last week, it means that the banks are either too weak financially to lend to each other or too worried about the ability of the other bank to repay them. Either way, it puts a crimp in lending. Banks serve as the transmission point for credit to the broader economy via business and consumer loans. When they're bogged down by their own bad investments or when risks increase, rates go up, lending slows, business activity decreases and GDP shrinks. It's a vicious circle.

The sudden surge in stocks is not a sign that things are back to normal, far from it. If anything, things are worse than ever. Credit remains unusually tight despite Bernanke's cuts to the Fed Funds rate or the creation of various “auction facilities” that remove mortgage-backed securities (MBS) from banks' balance sheets. Businesses and consumers are still having a hard time getting funding, which means that the velocity of money in the financial system is decelerating rapidly and this increases the likelihood of a system-wide freeze-up. Libor is just the flashing red light.

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A rise in Libor adds billions in additional interest payments for homeowners, businesses and other borrowers.

According to the Wall Street Journal, “Libor is one of the world's most important financial indicators. It serves as a benchmark for $900 billion in subprime mortgage loans that adjust -- typically every six months -- according to its movements. Companies globally have nearly $9 trillion in debt with interest payments pegged to Libor, according to data provider Dealogic.”

Commercial real estate deals are mostly pegged to Libor as are adjustable rate mortgages (ARMs). In fact, most of the mortgages that were written up during the boom years were tied to Libor. That's why Peter Fitzgerald, chief financial officer at Radco Cos., said, "If Libor were at 4 per cent instead of under 3 per cent, there would be a disaster that would take years to unwind.” (WSJ)

A rising Libor puts the Fed and the Bank of England (BOE) in a tough spot. They're trying to keep rates artificially low so the banks can increase their lending and recoup their losses, but the market is not cooperating. The market is driving Libor upward, which means the Fed is losing control. The real cost of money is going up.

The Bank of England was forced to intervene on Monday. Mervyn King, the UK's central bank governor, launched a “Special Liquidity Scheme” to “improve the liquidity of the banking system and raise confidence in financial markets while ensuring that the risk of losses on the loans they have made remains with the banks.” The plan will provide $100 billion for "illiquid assets of sufficiently high quality” (Mortgage-backed securities) to “unfreeze” bank lending. The plan is similar to the Fed's auction facilities which have provided over $200 billion in exchange for dodgy MBS, collateralized debt obligations (CDOs) and commercial paper (ABCP)

According to Bloomberg, “The Central Bank’s move allows financial institutions to add government bonds to their inventory of liquid assets and make it easier for them to raise cash and lend, especially to consumers seeking home loans. In return the government will hold the riskier mortgage-backed securities.”

The Bank of England said the swaps would be for a period of one year and could be renewed for up to three years, although the banks would be on the hook for losses on their loans. It’s a sweet deal for the investment banks and a total loser for the British taxpayer who could get stuck with hundreds of billions of worthless MBS.

The $100 billion liquidity injection is the biggest bailout in the bank’s history, and it was granted without public input or parliamentary authorization, just like the Bear Sterns transaction. The bankers call the shots while the public picks up the tab. The bank’s action puts to rest the idea that “the worst is behind us.” It isn't; in fact, recent estimates suggest that the losses to the banking system could exceed $1 trillion. There's still a lot of carnage ahead.

The $100 billion will help to stabilize the money markets and put the banks on sounder footing, but it does nothing to help the housing market. The British real estate market is on life support because most of the mortgage financing was coming from investors who bought MBS. Mortgage securities are currently down 92 percent from the same period last year, which leaves potential buyers without a funding source. The BOE is considering creating a British-style Fannie Mae to kick-start the stalled housing industry by providing government-backed loans. The private sector will not be a big player in the housing market for the foreseeable future.

The same is true in the US. If the Fed can't bring Libor down with interest rate cuts, then it will have to develop a back-up plan. The next step would be “quantitative easing,” a monetary policy that was implemented by the Bank of Japan in 2001 “to revive that country's economy that was stagnant for a decade. Quantitative easing entails flooding the banking system with excess reserves, resulting in pushing the benchmark overnight bank lending to zero.” [Reuters] There are indications that Bernanke is already preparing for this radical option, but there's little chance that it will succeed.

Whether the banks are able to lend or not is irrelevant. Public attitudes towards indebtedness have changed dramatically in the past few months. Overextended consumers are looking for ways to pay off their debts. This will make it more difficult for Bernanke to reflate the equity bubble through credit expansion. When people are frightened or pessimistic about the future, they naturally curtail their spending.

A recent poll conducted by the Washington Post/ABC illustrates how the public’s attitude towards the economy has darkened in a matter of months. According to the survey, “Nine out of ten Americans now give the economy a negative rating, with a majority saying it is in 'poor' shape, the most to say so in more than 15 years. And the sense that things are bad has spread swiftly. The percentage who hold a negative view of the economy is up 33 points over the last year, and the percentage who rate the economy 'poor' has increased 13 points in the last two months. That is the quickest 60-day decline since the Post and ABC started asking the question in 1985” [Washington Post]

The average American is showing a better grasp of the deteriorating economic conditions than the stock market. Housing sales continue to tumble, manufacturing is off, unemployment is steadily increasing, retail sales are flat, and inflation is soaring. Consumers are feeling the pinch of rising food and energy costs, loss of home equity and a general downturn in the credit markets. Money is tight and jobs are scarce.

Are you better off today than you were eight years ago?

When George W. Bush took office in 2001, oil was $28 per barrel, the euro was $.87 on the dollar, gold was $274 per ounce. Today, oil is a record $118 per barrel, the euro is nudging $1.60 on the dollar, gold is $945 per ounce. The country is presently engaged in a $2 trillion war in Iraq with no end in sight. The federal government has expanded over 30 percent under Bush. Wages for working people have stagnated, unemployment has risen, 47 million Americans are without health care, and the economy is slipping into recession.

Now the banks are buried beneath a mountain of bad investments and foreclosures are at record highs. In California, 65,000 homes are now in some stage of foreclosure while the total number of homes sold in February -- new and old -- was a mere 20,513.

The knock-on effects of the housing bust are just now rippling through the broader economy. Consumer spending is sluggish, growth is weak, and the stock market is more volatile than anytime since the 1930s. The Fed has usurped congressional powers to deal with insolvency problems at the banks. Public money is now being provided for the purchase of dubious assets held by unregulated investment banks owned by private speculators. The Fed is simply making up the rules as it goes along. Bernanke's actions have not yet been challenged by any congressman or senator.

The Fed's monetary policies have triggered a run-up in commodities prices, which is driving up the cost of everything from corn to copper. Food riots have broken out in capitals around the world and leaders are worried about growing political instability. The media are blaming drought, high energy prices, and biofuels for the sudden rise in prices, but these are only secondary factors. Currency devaluation has played a bigger role than shortages or blight. The world is awash in dollars which are steadily losing value. Pension funds and foreign central banks are diverting dollars into commodities rather than keeping them in corporate bonds or the sagging stock market.

Here's an excerpt from the Wall Street Journal that sums it up: “Inflation is rising throughout the world due to dollar weakness, and the prices of such commodities as oil and corn have soared. . . . As former Fed Chairman Paul Volcker noted last week, we are already in a 'dollar crisis.' Even the IMF -- typically the temple of devaluationists -- is alarmed by the dollar's fall. Dollar weakness has already contributed to soaring commodity prices that have walloped US consumers just when their spending is most needed to offset the housing slump. . . . The commodity boom is result in large part of the Fed's weak dollar policy, and it may have tipped the US into recession that could have been avoided.” [Wall Street Journal]

Foreign banks and investors currently hold $6 trillion in dollar-based assets and currency. When the dollar falls, speculation will increase and prices will rise. Currently, the US is exporting its inflation and fueling political unrest in the process. If Bernanke continues to slash interest rates, the problems will only get worse. The Fed could raise rates by 50 basis points tomorrow and the commodities bubble would explode overnight, but that doesn't look likely.

The idea that soaring commodity prices are the result of speculation is controversial. The economist Paul Krugman does not think that “low interest rates and irrational exuberance” are responsible for the high prices. Rather, he thinks they are the result of “rapidly growing demand and constrained supply.” This is certainly possible. Perhaps, there is no bubble at all.

Currency intervention to save the dollar

The G-7 finance ministers met in Washington last week and announced their “resolve” to minimize the volatility in the currency markets. Many people took this to mean that foreign central banks would take a more active role in shoring up the dollar. So far, there's been no indication of support. The dollar has stayed within the $1.58-1.59 per euro range for more than a week. Help could be on the way but, then, maybe not. The only one who can really save the dollar now, is Bernanke. All he needs to do is indicate that the rate cuts are over and the bleeding will stop. Bernanke has already cut the Fed Funds rate from 5.25 per cent to 2.25 per cent since September (way below the 4.1 per cent rate of inflation). It’s clear that he sees a deflationary tidal wave about to hit sometime in the next few quarters. Why else would he slash rates so aggressively?

Last week, former Fed chairman Paul Volcker took the unusual step of publicly chastising Bernanke in a speech he gave to the Economic Club of New York. Volcker's comments indicate the level of frustration with the Fed's dollar-savaging rate cuts which have caused problems around the world. Volcker said “The recession is not the Fed's problem. It's the government's. The Fed's job is to defend the currency and fight inflation -- exactly the opposite of what this Fed is doing.” The former Fed chief thinks Bernanke should raise rates now, because if he doesn't, he'll have to raise them even more later, “with even more awful consequences.”

Martin Feldstein, chairman of the Council of Economic Advisers under Ronald Reagan, joined Volcker in blasting the Fed and calling for an end to the rate cuts.

In a Wall Street Journal editorial on April 15 Feldstein said, “It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage. . . . Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries. In order to offset the inflationary impact of higher imported commodity prices, central banks in those countries may raise interest rates. Such contractionary policies would reduce real incomes and exacerbate political instability. . . . lowering interest rates stimulates economic activity to a point at which labor and product markets cause wages and prices to rise. That is unlikely to happen in the U.S. in the coming year. The general weakness of the economy will keep most wages and prices from rising more rapidly. . . . .But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices.

“Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates.”

Additional cuts will probably have negligible effect on housing and consumer spending, but they could be a fatal blow to the dollar. It's not worth it. Lower rates will be devastating for people living in poorer countries. In the US, middle class families spend only 15 percent of net earnings on food. In poorer countries people spend upwards of 75 percent of their income just trying to feed themselves. That's why riots are breaking out everywhere; the Fed's monetary policy is a catalyst for political instability.

Besides, lower interest rates don't necessarily increase demand or make credit more easily available. The only way to spark demand is to make sure that wages keep pace with production so that workers can buy the things they produce. In other words, a prosperous economy requires a strong and well-paid workforce.