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Listener Question

Listener Graydon Gordian has a question about our good ol' friend, the TED spread:

So instead of looking at the stock market you consistently use the TED spread as an indicator of current economic conditions and the reasons you've given for doing so seem very legitimate.

But I have never heard you discuss what might be limited or problematic about using the TED spread. Are there any common criticisms the indicator receives?

For those new to this scintillating discussion, the TED spread is an acronym formed from T-Bills (U.S. government debt) and ED, the ticker symbol for the Eurodollar futures contract. In plain English, that's the difference between the interest rate for U.S. Treasury bonds and the interest rate a group of a dozen and half banks in London borrow unsecured funds from other banks. Why London? In short, it just happened that way.

As Planet Money veterans know, the TED spread is often seen as a good measure of financial jitters. If banks believe that their peers are solid, they are 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, it's a sign of fear.

What Graydon wants to know is: is the TED spread really that accurate? And could there be a better way to measure market risk?

Some say yes. Their beef is with the LIBOR half of the equation and, indeed, a growing chorus of investors, economists and policy makers want to find a better benchmark for market risk.

As they see it, LIBOR has two principal problems: (1) the mechanism used to set it is off and (2) the banks that set LIBOR aren't representative of all market conditions, including those in the U.S.

They say the basic problem is that LIBOR is an arbitrary rate that is determined by a cartel of 16 foreign banks in an opaque and manipulated process. Because of that, the rate could be too high at some point and too low at others.

It's not a small point. As much as $350 trillion in outstanding mortgage loans, student debt and credit cards worldwide are indexed to LIBOR. So it's a big deal if the benchmark contains even a small error.

What to make of all this? It's not so easy to say. There are alternatives to LIBOR but they have their downsides too. And this may not be the best time to be playing with some of the basic tools of the credit markets.

One thing is for certain. The debate is nowhere near over, so you can expect to hear about these fun terms like LIBOR and the TED spread for quite some time.

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