When economic historians look back on the events of August-September 2007, they would note that the week of 17 September marked the victory of the political power of the financial sector over the central banks. In a period of two months, the sector rewrote central banking and converted the objectives of all of them into one sentence: “To ensure continuously rising asset prices at any cost.” The consequences are going to be profound. Central bank governors could find undergraduates vying for their jobs as monetary policy is reduced to a mechanical rule: Cut when asset prices drop and stand pat when they rise.
With a display of histrionics that would have put even Bollywood films to shame, Wall Street types beat their breasts in public and with borrowed hands, when two were not enough, over events that they characterized as a crisis that has not been seen in a long time. Discount rates were cut and liquidity support was given. Central bank lending horizons were lengthened. Acceptable collateral categories were extended even to toilet paper rolls. It was just as well for that was the only paper that was not marked to model. These were not enough. Financial institutions wanted their familiar diet of low interest rates. The issue was not relief from distress, but sustaining the business model built on low interest rates and debt. In other words, the message was: Grant us relief from follies, but also help us to commit more of it again, or else.
The Fed capitulated. It doubled, nay, quadrupled the booty. The Federal funds rate was cut by 50 basis points and so was the discount rate by another 50 basis points. Guess where the stock markets are now? They are back near their highs for July or even better. Erased was the swoon of August. Prices of asset-backed securities are near their highs and commercial paper yields are close to normal levels.
The drama had worked and central bankers have been successfully blackmailed into halting their rate increases and even pushed into lowering rates. For problems and imbalances caused by low interest rates and excess leverage, the cure has been delivered: low interest rates. Lower interest rates are administered for economies suffering from low aggregate demand. Here, interest rates have been dropped as an answer to problems caused by too much of demand.
The one bank that intended to stand up—the Bank of England—has been beaten down. The governor was forced to eat humble pie. He had to abandon the principles by which he wanted to play the role of the lender of the last resort. The British Bankers’ Association has praised his “flexibility”, but wants him to lend not at penal rates, but, yes, you guessed it right, at lower interest rates.
The logic is simple. Not only should they be shielded from facing the consequences of their misdeeds, but they also ought to be rewarded for them. Martin Wolf observed aptly in “The Bank loses a game of chicken”, Financial Times, 21 September, that Mervyn King, governor of the Bank of England, played a game of chickens with the world’s most irresponsible industry and he lost.
In the meantime, by getting the Federal Reserve to cut rates aggressively, the sector has been ingenious in getting other central banks to fall in line, indirectly. In a globalized world, one central bank cutting rates would not do. By getting the US to drop rates and thus causing the US dollar to plummet, other central banks are forced to stare into two stark choices: Either let the currency become uncompetitive or cut rates, intervene, boost money supply and asset prices. Those central banks that were concerned about overheating in their economies would become more concerned, but they would be able to do little about it.
Unsurprisingly, financial markets are celebrating. They are correct to do so, for now. If more money is thrown at financial assets, their prices go up. Whether it would last or not is hard to tell. Not many care for the answer. This column argued last week that the attempt at reflating was less likely to succeed given that American households were already satiated with debt. But that lies in the future.
For now, risk and carry-trade are back. Volatility in the markets is sharply lower and bearish investment advisers face the choice of either sticking to their convictions or their jobs. That is hardly a choice. Over time, inflation would creep back. Central banks were forced to abandon their inflation watch for good this week and the ramifications would be felt in 2008 and beyond. The good news for males is that it is going to be possible to be a smart investor and a sensitive husband at the same time. Put differently, male readers can get considerably richer by buying gold and silver jewellery for their wives over the next several years.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org