The Proposal:
We should provide the federal reserve with a new regulatory instrument that aims to reduce the incentive for new bearish trades made with borrowed funds. This can be accomplished by regulating the amount of margin available to new positions based on whether or not they are bearish.
At Issue:
On January 22nd the stock market continued an aggressive downward spiral leading the Federal reserve to issue an emergency rate cut of 0.75%. This rate cut came amongst a fury of other rate cuts. Are rate cuts an appropriate way to deal with a market that is dropping very fast? The Federal Reserve Bank of New York has an excellent historical list that shows the discount rate and the federal funds rate over the past few decades.
These recent cuts have brought the overnight lending rate to 2.25% from 5.25% a year ago. Though, it should also be noted that the rate has been lower historically, as recent 2004 and 2003. In the past providing liquidity by cutting the lending rate has usually lessened the load of recessions; however, I feel the present situation is vastly different than any the US economy has faced. The events of September 11 came in the midst of the boom cycle, leading to an out-of-season recession. To lesson the burden of that recession the government lowered the interest rates. Although they raised them again after the economy began booming again, the rate today would have been higher if they were not forced into cutting drastically earlier. A higher lending rate would have provided the Federal Reserve more breathing room when it came to cutting the lending rate to provide liquidity to the market.
The Proposal:
The proposed method should only be applied to new positions. Forcing a change in the margin requirement of existing positions would falsely cause a number of trades to be pushed into a margin call, independent of whether or not the trader left themselves adequate breathing room. Since these calls would lead to a forced booking of profit or loss, the market would move as a direct result of government intervention. This would grant the reserve to much power in the form of influencing the general trend of the market (leading to over inflated markets and an eventual crash when people loose faith in the system).
Instead, the idea is to prevent the amount of borrowed money that is put into the market. Since this money is borrowed from brokers, who borrow from banks who ultimately borrow from the government, it makes sense that the government be able to restrict the amount of leverage available in one direction or the other. This would not necessarily slow down the sharp swings in the market, based on the efficient market hypothesis, injecting liquidity is only going to increase the number of trades not the value of the market's assets. Most traders are aware they need to pay back their margin so this should come as no surprise.
Such an instrument would be a finer tool to use rather than the blunt tool of reducing the overnight lending rate, in terms of what the reserve has been trying to accomplish over the past year.
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