Friday, August 17, 2007

Another Example of English Economic Wisdom

Why is it that we often read more sense coming from across the water than right here in our own "land of the free market"?

rogerbootle
[Thanks to UKbudget.com for the photo.]

Roger Bootle (how English is that name?) makes great sense in an article I read in The Daily Telegraph of 8/13/07. He says:

"Normally the young men who dominate the money markets pile out squillions to other banks at the drop of a hat, and with scarcely a thought about the borrower's balance sheet. The assumption is that most banks are all right. It is this assumption that ensures the general liquidity of the system. But when things go wrong confidence is fragile. The dealers do not know that a bank is in trouble until it is too late. So rumour and suspicion hold sway. In these conditions, they may become generally unwilling to lend to any but the most topnotch banks and, accordingly, the interst rates facing most banks may rise uncomfortably.

"Dealers would rather buy government bills or simply leave their cash sitting in the account with the central bank. There is then the danger of a real liquidity crisis.

"It was to fend this off, that last week the ECB [and the US Fed, et al.] provided funds, making the markets awash with money, thereby serving to bring interbank rates back down."

He goes on to explain why a credit crisis has affected the stock market and all industries, not just banking. He cites these reasons:

1. Tight credit for banks means tight credit for all companies.
2. Risk is now being reevaluated, and therefore risky investments like stocks are adjusting to their proper level (i.e. down).
3. These disruptions make markets uneasy about the health of the underlying economy, which may mean lower profits.

He forgot this one:

4. Those credit-rich speculators (hedge funds, banks, pension funds, and individuals) who have put everything they own, and then some, into the stock market (especially those on margin accounts) have pumped the markets up to dizzying heights, and now they've getting the bejesus scared out of them as their stop-loss sales and margin calls kick in.

Then Mr. Bootle discusses the role of the central banks in all of this. He makes great sense.

"What should central banks do? The principles are fairly clear, even if the practice is murkier. It is not the job of central banks to protect the shareholders of imprudent or even unlucky lenders from the consequences of their actions. It is, though, part of their job to prevent worries about one institution [in this case, maybe all of the top ones] from causing a general liquidity crisis."

So they did the right thing in pumping liquidity into the system. BUT, he continues, the central bankers should NOT "easily be defected from their course." Right on, Mr. Bootle.

But there's a difference between what they should do and what they will do. "There were rumours swirling around the market that these events made cuts in interest rates by the Fed more likely and rises in rates by the ECH and the Bank of England less likely. This was misjudged." Ah... here we might have a diversion of opinion.

I think the markets are right, the Fed and other central banks' convictions will melt away like a sorbet in a Brazilian sun, as soon as they convince themselves that without action, the global economy will sicken.

I know that "[p]roviding liquidity is the right thing to do if the market is suffering from a liquidity crisis" and that "[c]utting interest rates is only appropriate if this crisis threatens to have serious adverse effects on the economy." But these deleterious effects are impossible to predetermine until it's too late, and the banks will want to act peremptorily, so as to appear as though they have saved us all from ruin.

"In any case, central banks have to be careful about responding too readily. Otherwise the markets will operate on the basis that they are protected on the downside and accordingly take off on even more exaggerated flights of irrational exuberance." Aha, but there is the rub. The markets already KNOW that Bernanke's Fed and the others will indeed respond.

AS INDEED THEY HAVE. Today, they have lowered their discount rate from 6.25% to 5.75%. (Not their target rate, which is still at 5.75%; but this is an important psychological move.)

Mr. Bootle then goes on:

"This was the position that Fed chairman Alan Greenspan got himself into. So sensitive was he to the dangers of a financial collapse causing major economic effects that he established a record of cutting rates in response to financial crises. He did this after the stock market crash of October 1987, the savings and loan crisis in the 1980s and, most importantly, after the dotcom collapse and the terrorist attacks of 2001."

Now we can add that Bernanke and his friends have perpetuated Greenspan's tradition, setting the tone for the future--very bad news for the dollar (indeed all fiat currencies), for the small guy, and for the future of all of us, even though it may feel like a relief at the time.

"Markets came to feel that they were protected by the 'Greenspan put'. I doubt very much that the new Fed chairman, Ben Barnanke, wishes to preserve this particular inheritance from his predecessor."

Well, I think you are mistaken here, Bootle. Bernanke is just as much concerned about his image as Greenspan and will not play party pooper either.

Now here is where Bootle does his finest work:

"Indeed, you can attribute the collapse of risk spreads on almost all instruments (until recently) to the combination of the low interest rates enacted by central banks to offset the effects of the dotcom collapse and 9/11, and the idea that because of central bank interventionism, the risks in the system were now much lower or even non-existent."

He ends the piece with confidence in our central banks' willpower to continue on their present inflation-watchdog course, at least until the situation gets really bad and some big banks have had to bite the bullet. Personally, I don't think our monetary police will have enough guts to wait that long. As I've said in this past post, this post, and this post, they lose either way. Damned if they do, damned if they don't.

We're in for a great ride.

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