The $360 Trillion Problem

The LIBOR rate affects $360 trillion worth of financial products, including adjustable rate mortgages, credit cards, and auto loans. That's because banks use LIBOR to set interest rates for these products, usually charging a point or two above LIBOR, which is usually 1/10th of a point above the Fed Funds rate. Since LIBOR is now a full point above the Fed Funds rate, that is like an additional $3.6 trillion in additional interest that is being charged to borrowers.

Think of the $3.6 trillion as a "fear" tax that is dragging down the global economy, but contributing nothing in return. That is why the Fed is trying to lower LIBOR by lowering the Fed Funds rate to virtually zero at this weeks FOMC meeting. The problem will be what happens if LIBOR again rises due to fear, just as it did in October when LIBOR was 4.3% when the Fed Funds rate was 1.5%? I doubt that this will happen, but if it does then the Fed would have no leverage on LIBOR, since it can't lower the Fed Funds rate below zero.

What It Means to You

The size of the problem is mind-boggling. LIBOR affects $360 trillion in financial products. To try and put this into perspective, the entire global economy "only" produces $65 trillion in goods and services. The entire budget of the Federal Government is $2.9 trillion, which is less than the cost to the global economy if LIBOR rises one point. In other words, the Federal Government can try and restore the global economy, but the size of it has become so large that it will take probably take a paradigm shift to solve it. It will definitely take the combined efforts of many, many smart people...including the readers of this blog.

(Source: Bloomberg, Dollar Money Market Rates Tumble on Fed Rate Cut Speculation, December 11, 2008)

Related Reading

• Historical LIBOR Rate
• A Primer on the Role of Interest Rates in the U.S. Economy
• 2007 Banking Liquidity Crisis