What is a Central Bank To Do When the Markets Lose Balance?

Location: New York
Author: Shahin Shojai
Date: Monday, September 10, 2007
 

Ever since the credit crunch hit the financial markets, professional economists, and in fact anyone else who feels they wish to say something about what is happening, including yours truly, have been suggesting that central banks should not reduce rates in order to help those in trouble. The argument goes that those who invested in risky assets should suffer the consequences. The central bank’s job is not to bail out those who make mistakes, but that it should only get involved when there is a short-term dislocation in the markets.

Now, I might be wrong here but isn’t pumping billions of dollars into the financial markets to keep the inter-bank rates lower than what the markets have determined them to be doing just that? Isn’t this just another way of forcing rates to be lower than they should be to compensate investors for what they perceive to be the increased risk in lending? Those who wish to avoid a financial crisis suggest that this is just a short-term support for the markets until they get their bearings, after being punched by a huge shock, and not a cut in interest rates.

Well, then if that is the case, why are all the economists suggesting that the decision by the ECB and the Bank of England to keep interest rates on hold is the right one? If this is a short-term phenomenon, and as Mr. Trichet suggests the fundamentals of the economy are still strong, why should the central banks not raise interest rates as they had planned? They can do both, help keep inter-bank rates in check while increasing interest rates to control inflation.

The problem is that no one really knows what has just taken place and how wide its ramifications could be. We all know that most professional economists have no idea what is really going on here and what needs to be done to correct it. As far as most of them are concerned, the lower the inter-bank, or general, interest rates are the better it is for their employers. Consequently, when the two central banks declared that rates would be held as they are they all stated that it is a very wise decision since we need more time to know what will happed.

Well, the truth is that what happens is highly dependent on how the central banks behave. The direction of causality in this case is very strongly from the central banks to the markets. If they keep rates low many of those institutions in trouble will have time to rescue themselves, but of course the markets miss their opportunity to punish those who made a lot of money from taking on the wrong types of risks. If they increase interest rates, assuming that Mr. Trichet is right, then many would fail and no one really knows how many that would be. And that is the crunch of the story. No one really knows how many would fail.

Additionally, many overlook the fact that increasing interest rates does not only punish those who made mistakes; it also punishes many banks that were managed prudently, and many individuals who had nothing to do with the U.S. property lending disaster.

So, what should the central banks do? It all depends on whether they wish to create a small recession to help the economy correct some of the past mistakes or wish to delay the crisis. We have seen examples of both. When the Federal Reserve increased rates to burst the Internet Bubble, or even in the 1920, the economy experienced a dramatic slowdown. I am sure many will remind me that the economy quickly picked up again subsequent to the last slowdown, and we did not even experience a genuine recession. But the fact is that the rates were in fact cut quite rapidly once it became clear that the risks of a major slowdown are huge.

The markets were also helped by the tax cuts introduced by the Bush Administration. The culmination of the cuts in rates and taxes has been the huge property bubble that looks like it is about to burst. Consequently, what the Greenspan Fed did was to simply postpone the crisis, whereas in the 1920s the crisis was made imminent by the hike in rates. Sadly, it is not clear whether postponed crises do in fact happen. There are  not many precedents of situations where crisis were postponed to see how severe the subsequent crisis in fact was. It is also not clear whether it can be delayed by so long that it actually never transpires.

The next action of the Fed will simply decide where and when the next bubble would be. If the rates are kept low, or even lowered, we might see another stock market bubble created, and the property market falls would be more controlled. If the rates are hiked there is a genuine risk that the major, and not modest, recession that should have transpired in 2001, subsequent to the stock market crash, would take place now; assuming that crisis cannot be delayed indefinitely. There are very few examples of controlled mild recessions, but many examples of tight monetary policy forcing a harsh one.

I personally believe that most central banks are aware of this fact and wish to avoid people even mentioning the word financial crisis, which is why they are being very soft on rates. They are fully aware that this is not a short-term problem, but that in fact it could become a major economic problem for many countries that also have the same property market problems as the U.S. Of course, most would deny that there is the same extent of problems in the U.K. or Spain, but somehow the same shortages of property were also mentioned in the U.S. not so long ago. Whenever there is a bubble, people feel there are shortages. When the bubbles burst it becomes clear there were huge surpluses, except that few would sell in the hope of prices rising. As always, it is the speculators who determine the levels, and their actions are dependent on how much of a punishment the central banks feel should be handed out to them. 

That is the real issue at hand. When the central banks wish the bubble to be burst and how much control they could have on it when it happens. Today, the risks are just too large to test the proposition. Unlike most stock market bubbles, when property bubbles burst, especially in the kind of high credit environment that is prevalent in many Western economies today, the risks of a major recession is huge. They may also be hoping that by keeping rates low, or even lowering them, in times of crisis that they can simply delay crisis indefinitely.

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