Caroline Baum posed the right question in one of her recent Bloomberg columns. This was after at least six of the world’s leading central banks cut interest rates. She said the offer of lower interest rates as a solution to the boom-bust problem caused by low interest rates was daft. She has a point. Or, rather she had a point. The same point was made by Bare Talk almost a year ago when, at the onset of the crisis, the US Federal Reserve furiously slashed the federal funds rate and the discount rate. Bare Talk had suggested that the notion that low interest rates were a solution to the problems caused by low interest rates was to be dismissed with the contempt it deserved (Mint, 7 August 2007).
Yet, in a missive to clients on the morning of the coordinated rate cuts last week, I had argued the case for coordinated rate cuts citing both its symbolic and substantive value. Its symbolic value arises from the display of leadership and purposeful action with underlying global cooperation. Its substantive value arises from the fact that economic conditions and the outlook have changed materially from last year.
The augmented unemployment rate in the US stands at 11.7%. Nearly one in eight Americans is unemployed. Commodities—crude oil and industrial metals—have slumped and shipping freight rates have crashed. Very soon, the euro zone and the US would be seeing declines in monthly consumer price index inflation, although annual inflation rates might take time to drop, given base effects from last year. So, the economic case for lower interest rates is far more compelling and justifiable now than it was last year.
In fact, policy interest rates in the US and in the euro zone will be at or near zero in the next 12 months. The economic pain arising from the calamitous events in the financial markets and in the global banking sector are yet to be understood and discussed. Most of us prefer to be in the “don’t ask, don’t tell” mode for bad news until it is too late to protect ourselves from its consequences.
Nonetheless, what this volte-face on rate cuts shows is that, in economics as in finance, theory or ideology should take a back seat to the context and circumstances. That is the lesson Henry Paulson is learning about recapitalization of near-insolvent financial institutions.
The comment Ben Bernanke made in defence of the US government action in not rescuing Lehman Brothers in his speech to the National Association of Business Economics last week went unnoticed. He said a federal loan to the failed institution could not be made since the required collateral was not available. This was too important a remark to be ignored. In other words, the US government did not think that the collateral at Lehman had enough value to offer adequate cover to the federal loans required. It logically follows that the value of assets held by other institutions should have a similarly low value. Therefore, if the treasury’s troubled asset relief programme had to work, the treasury has to buy them at much higher prices. That is, the expected price recovery of these assets has to be delivered in the present to these institutions denying much of the upside to taxpayers.
Given this reality, it makes much sense for the government to inject cash in return for equity stake in these institutions and wipe out current equity holders against current losses. The recognition of losses and the new infusion of cash should make them solvent enough to resume normal financial intermediation in due course.
In other words, the US government has to swallow its resistance to nationalization of financial institutions because the context and the circumstance demand it. Paulson has given enough hints that he recognizes the inevitability of this step.
Together with the measures that other governments in Europe would be announcing to nationalize banks in their countries, a temporary ceiling to the panic should be at hand shortly.
Many long-term challenges remain. The first one is the ammunition that this crisis has given to those who want the state to run the economy. Second, the speed with which the crisis reached very alarming proportions suggests that the psychological costs of this crisis will be substantial.
The third challenge is to start to count the economic costs and to anticipate the geopolitical power shifts that this crisis would entail.
Further lower in the “challenge-chain” is the stance investors should be taking. The hoped-for respite might be at hand, now that governments appear to be fully awake. However, if investors feel that it is an opportunity to add risks now rather than a window to eliminate some, they will have only themselves to blame if they find themselves joining the ranks of the abjectly poor in another two-three 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