Panic button

Panic button
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First Published: Wed, Jan 23 2008. 11 11 PM IST
Updated: Wed, Jan 23 2008. 11 11 PM IST
Expectedly, the Indian stock market staged a smart recovery on Wednesday.
This was after Ben Bernanke threw a hurried lifeline to investors on Tuesday. The US Federal Reserve’s sudden and deep 75 basis points cut in interest rates is widely expected to pull the world’s largest economy out of trouble and keep the rest of the world economy on track. Equity investors have almost blind faith in the ability of a central bank to bail out an economy in trouble, especially if that bank is the Fed. This belief in an omniscient and omnipotent central bank is touching—and dangerous.
There is little doubt that monetary policy is usually an effective tool to combat a slowdown or recession. It has emerged as the most potent weapon in the armoury of national policymakers, displacing good old Keynesian fiscal policy.
However, lower interest rates work best when individuals and companies use cheaper money to buy and invest. It is not hard to figure out that the situation on the ground in the US is quite different this time around. The credit markets continue to reel. Housing is in a mess. More generally, the financial sector in the US and Europe is still in a state of panic.
Short-term interest rates affect the real economy through various transmission channels —credit, interest rates and asset prices. Many of these channels are blocked right now. The question is whether the new gush of money that the Fed will pump into the economy will unblock these channels. It is hard to say for sure. But investors would do well to remember some counter-examples of economies that did not respond easily to lower interest rates.
The most well-known example is Japan. Its huge asset bubble was pricked in 1990. The Bank of Japan subsequently cut interest rates all the way down to zero, but to no avail. Japan struggled with debt-deflation for more than a decade. Economic growth was almost non-existent. Things started looking up a bit only after Japan’s banks were reformed in the early years of this decade and their balance sheets were cleaned up.
The US today is in many ways in a similar spot to what Japan was in the early 1990s. A huge asset bubble is deflating, especially in housing. Banks are nursing hundreds of billions of dollars to problem loans. Ownership of derivatives backed by mortgages makes the tangle even worse. The situation is far more complex than it was in 2001, when the US economy responded quickly to interest rate cuts and got away with a short and shallow recession.
It’s because of factors such as these that economists and investors in the developed markets have greeted the US interest rate cut with more trepidation than their peers here have done. Their concern: What data has Bernanke seen that made him go in for such a sudden and deep cut in interest rates? One possibility is that the Fed chairman has hit the panic button in the face of a market meltdown. But will that help? As a writer in Calculated Risk, the highly-regarded blog on economics and investments, puts it: “The Bernanke Fed is like a 19-year-old army trainee who’s never fired a shot in anger and is suddenly dropped behind enemy lines with an Uzi. He’s shaking in panic but gripping his trusty gun tight, secure in his ability to destroy whatever foe he comes across. The problem is, he fires off a half-clip in panic every time the wind rustles the trees. Pretty soon he’s going to stumble right into an enemy squadron and pull the trigger, only to hear the fateful ‘click-click’ that indicates he’s out of ammo.”
We tend to agree with this assessment. The rate at which the Fed is using up the tools available with it to protect investors from their own mistakes could mean that it has little left in its armoury to fight a more serious battle in the months ahead.
(Will lower US interest rates stall a global slowdown? Write to us at views@livemint.com)
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First Published: Wed, Jan 23 2008. 11 11 PM IST