LIBOR: Fear meter, or shock generator?

[I'm stickying this because, dammit, it seems unfoily to me, and everybody's assuming LIBOR is some sort of neutral measure. Takedown, anyone? -- lambert]

Bloomberg has an interesting article whose headline, if taken literally, puts shock doctrine right out into the open:

Libor Holds Central Banks Hostage as Credit Freezes?

(Note the usual lack of agency. LIBOR's just a number. How can a number hold anyone hostage? Only sentient beings can hold each other hostage.)

Anyhow -- with the usual caveat that I'm trying to learn all this stuff as I go along, and anybody who steps in with clarification or a takedown will be doing a public service -- LIBOR is the London Interbank Offered Rate, a "daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). " It's one component of the TED spread, a number Krugman warned us to watch back in February:

The TED spread is the difference between the interest rate banks charge each other on 3-month loans (3-month LIBOR) and the interest rate on 3-month U.S. Treasury bills. It’s a measure of financial jitters. If banks believe that their peers are solid, they should be willing to lend each other money on almost the same terms as money lent to Uncle Sam. When they start demanding a big interest rate premium, that’s a sign of fear.

Hold that idea, "measure of fear," in mind. Because LIBOR has an interesting backstory. Let's read on in the article we originally started with:

Rising Libor, set each day in the center of international finance, means higher payments on financial contracts valued at $360 trillion -- or $53,500 for each person worldwide --including mortgages in Britain, student loans in the U.S. and the debt of companies like CIIF in Makati City, the Philippines.

The process of setting Libor is overseen by the British Bankers' Association, putting it outside the domain of central bank policymakers. The overnight dollar rate fell 29 basis points to 5.09 percent. That's still 359 basis points more than the U.S. Federal Reserve's benchmark rate.

In other words, LIBOR is unregulated, and a consequence of deregulation -- thanks to Maggie Thatcher:

The BBA began producing the unified rates known as Libor in 1986, an association spokesman said. That made Libor the natural benchmark when then-Prime Minister Margaret Thatcher abolished many restrictions on trading in the U.K., leading to an explosion in the range of products on offer, said David Clark, former head of funding at European Investment Bank, the European Union's Luxembourg-based development bank.

The process of setting LIBOR is entirely opaque:

Libor is set through a daily survey by the London-based British Bankers' Association. As many as 16 banks, including UBS AG, Citigroup Inc. and Bank of America Corp., report the rates they think they can borrow at in 10 currencies and maturities ranging from overnight to one year.

And in fact, nobody knows for sure why LIBOR is what it is:

While the estimates that go into Libor used to be based [what does that mean?] on actual transactions between banks, they have become little more than guesswork since credit markets froze, according to three people with knowledge of how interbank rates are set. They spoke on condition of anonymity because they weren't authorized to discuss rate setting.

`I Don't Know'

``Whatever answer you give is by definition wrong,''* said Meyrick Chapman, a strategist at UBS in London. ``There is no interbank lending, so the only proper answer to where could you fund yourself is `I don't know' or `I can't.'''

What good is a "measure" that doesn't work in a crisis? It's as if the thermostat in your house stopped working as soon as it got cold!

Well, it is no use. Maybe that's because it's not a "measure" at all?

So let's back up. When economists and journalists (among, Krugman) call LIBOR a "measure of the jitters," that's not a statement of fact; it's a hypothesis.

What if LIBOR is not a thermostat for fear, but the needle on a financial shock generator -- wired up to the stones of everyone round the world who needs credit? As I wrote:

I have yet to see anyone confront and refute Newberry’s theory that the crisis is caused by greed, not fear. (After all, if you were in a posse of infestment bankers, and you could get the government to hand you a trillion dollars, no strings attached, just because you “freeze” interbank lending and cause other people a lot of pain, what would you do?*)

LIBOR is set by private parties. It is not regulated. The process is opaque. Sources call it "guesswork" now, but for all we know, it's always been "based on" nothing; there's no way to know for sure, because there's no transparency

And it's certainly a reasonable hypothesis that the private parties** who set LIBOR in London don't take the Tube home to a little bit of a garden in the burbs; they like money, a lot; they have money, a lot; and they'd like to have more money. A lot. In fact, one of the things about greed is that there's no limit it to it, so they'll squeeze the lemon 'til the pips squeak.***

In fact, the only reason to trust LIBOR as a measure opposed to a manipulator -- compare Soros on "reflexivity", a "shock" metaphor if ever I heard one -- is a vague feeling that "No! They would never do that!"

Well...

NOTE * So, LIBOR is like the Rapture Index, then?

NOTE ** Cf. Dante'sInferno, Circle Four (Greed_:

Now canst thou, Son, behold the transient farce
Of goods that are committed unto Fortune,
For which the human race each other buffet;

For all the gold that is beneath the moon,
Or ever has been, of these weary souls
Could never make a single one repose."

NOTE *** Bloomberg was another interesting headline, with an interesting metaphor:

Central Banks Fail to Alleviate `Logjam' in Libor

Well, every log jam has a key log. If it's a reasonable hypothesis that LIBOR is being manipulated, then the guys who are manipulating it are the key log. G7 has its weekend work cut out for it! Hmmm... More weekend work......