In short, neither economic theory nor established economic evidence provides any basis for the belief that further monetary intervention and distortion would ease any binding constraint on the real economy at present. This does not, of course, rule out the possibility of speculation grounded in superstition and a misguided impulse to reach for yield, but the Fed’s ability to weave yet another set of Emperor’s Clothes is justifiably deteriorating.

A point we have been making for several years has been the inappropriateness of treating a solvency problem as if it is a liquidity problem. We would add that institutions that repeatedly risk insolvency because of liquidity issues deserve their insolvency, but then we are considered obstinately frugal with public funds and public risk.  John Hussman makes the point well when pointing out that Fed policy does not keep banks solvent:

As a final note, since the likelihood of fresh credit strains is rapidly increasing, it’s important to recognize that reserves are different than capital. Reserves represent funds that the bank has taken in through deposits and which have not been used for new loans, securities or other investments. Capital is the difference between the assets of a bank (regardless of whether they take the form of loans, securities, or reserves) and the liabilities it owes to depositors and bondholders of the bank. Too little capital, and a bank has no cushion against insolvency – assets might fall short of the amount needed to satisfy liabilities. So keep in mind that if a bank loses money on loans or other investments, those losses can cut deeply into capital even though the bank is highly “liquid” on the basis of reserves. Fed actions to inject “liquidity” can help a bank satisfy demands for cash if depositors cut and run, but those actions do not add to bank capital, and do not improve the solvency of the bank.

As always, read the whole thing.

The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.

-GK Chesterton

That by the way, is my favorite quote of all time. Its implications for those investors engaged in various forms of financial engineering are enormous.  Models are useful, until they very much are not.