Despite the Fed's rescue, debt markets are still freezingBy Ambrose Evans-Pritchard
04 Mar 2008
SourceI have found it hard to see clearly through the economic and financial fog of the last two months. Pundits should shut up if they have nothing to say. So I did.
The Fed’s emergency rate cuts in January briefly seemed to change the picture. There was hope that the most dramatic easing in a quarter century would start to thaw the credit freeze.
Obviously, this has not happened. Almost every measure of credit stress is now at danger levels again, although US commercial paper is regaining a little colour.
My Monday column caused a storm.
So let me answer the collective critique by the hundreds of readers who sent comments.
I was variously called a Bush-hater, a visceral anti-American, a Keynesian, a teenage scribbler, and a “hard Left” agitator. That last one cracked me up. (For the record, I am a Burkean conservative, aged 50, with a libertarian bent, and a penchant for Monetarist and Austrian economics – though Keynes had a point in the Slump).
Let events judge whether I am scare-mongering. In the hierarchy of errors, complacency may prove to be the greater sin in the end.
The deep concern of bears is that the Bernanke-Kohn duo at the Fed may feel constrained from cutting raises as quickly and as deeply as they want because economic consensus is still underestimating the “credit channel” and “financial accelerator” dangers of this crisis. (To use two terms that Bernanke favours from his life-long study of depressions).
The risk is that they will wait too long to act - against their better judgement - because they cannot move too far ahead of bond vigilantes and commentators who are still fretting about inflation, as indeed are the Fed’s own regional board members.
This is what happened in 1930, when Sprague, Warburg, Hamilton, Robbins, and other governors loyal to the Real Bills Doctrine refused to cut rates, fearing a false inflation long after the threat had switched to deflation.
It happened again in Japan in 1990, when a mini-price scare pushed inflation to 4pc. The Bank of Japan overacted, holding rates at 6pc for too long.
By the time they recognized the error, events were spiralling out of control (although that is not the full story, of course).
Inflation lags the cycle. It always spikes highest at the end. Central bankers have to look ahead.
Who pose the greater danger to the world economy right now? The prophets of the credit crunch, or the prophets of inflation?
Those warning of a very severe crisis – Nouriel Roubini, Michael Panzer at Financial Armageddon, Doug Noland at Prudent Bear, Yves Smith’s Naked Capitalism, and many others — are all serving a vital social role.
The bears are helping to strengthen the hand of Ben Bernanke at a critical moment. On this side of the Atlantic they are giving cover to the doves at Bank of England, the European Central Bank, et al, who sorely need it.
Am I wrong about inflation? Perhaps. It is a tough call at the turning point of the cycle. There is certainly evidence that we may be on the cusp of a wage-price spiral akin to the early 1970s. Commodities are flashing warning signs. Yet, I suspect that the greater danger lies on the other side, as Bernanke and Kohn clearly now believe.
Yes, 40pc of the world economy has an inflation problem. China (7%), Vietnam (15%), Russia (12%), Bulgaria (12pc) Romania (8%) Estonia (11%), The Emirates (12%) Qatar (14%), India (5). Some are of course importing inflation through dollar and euro pegs or dirty floats. Silly them. Fed/ECB policy is totally unsuited to their needs. But this is changing. China is revaluing at an annual rate of 15pc. Hungary broke its euro peg last week.
Most of these countries are now tightening hard. As the effects of their collective monetary squeeze feeds through, it may compound the downturn already gathering force in the US, UK, Europe, and Japan. The Old Guard still make up 60pc of the world economy. Japan is at risk of tipping back into deflation as the yen surges (up 20pc viz the dollar since July). Much of the Atlantic sphere faces property busts of varying degrees.
As many readers point out, it is too early to judge whether the Fed Rescue has “failed”. What I meant is that it has so far failed to normalize the debt markets. It has reached the point where counties in Alabama are unable to raise money.
Monetary policy takes a year or two to filter through so the 225 basis points in cuts since September will gradually work some magic.
It is true that the mortgage resets peak in March and that a big chunk of the adjustment has already occurred. But the impact on the housing market and on the default rate on CDO mortgage securities takes a long time to unfold. Nobody is evicted instantly. It takes months to exhaust the arrears process. The legal machinery drags on. It then takes months more to sell the house into a falling market. US property busts typically run for four or five years, according to a Fed study.
Yes, Wall Street has held up OK, although the S&P 500 is testing the lows around 1300 once again. Tokyo’s Nikkei has come down much further, so has Shanghai, and most other emerging market bourses.
But be careful. Credit stress often precedes equity stress by five or six weeks, so there may be worse to come for Wall Street. The currency markets are signalling trouble. The yen and Swiss franc are surging again.
My guess is that the Fed will have to cut much further. It will need a lot of help from the BoE and the ECB before we start to glimpse recovery. Warren Buffett said this week that he was waiting for shares to get a “lot cheaper” before jumping in.
One last point. I totally agree with those who blame the debt crisis on the irresponsible policies of the Fed and fellow central banks from 2003 to 2006, and indeed for better part of fifteen years. They stoked this bubble by artificially holding rates too low (by government fiat). The money leaked into asset prices, just as it in the US in 1920s, and in Japan in the 1980s. (Two other low inflation eras).
In effect central banks rigged the price of credit. In doing so they caused massive “inter-temporal misallocations”, to use the posh term of the BIS. Or put another way, they stole prosperity from the future. The future has now arrived.
Yes, one could call for a liquidation purge to clear the excesses. That would be ideologically purist. But we might ruin our democracies in the process. So first we must right the ship, even if that means moral hazard and a despicable bail-out for the credit villains. We must hold our noses. We settle scores later.
Von Hayek argued that governments themselves are the cause of extreme ups and down in the credit cycle. He said they should be stripped of their power to control interest rates, reducing central banks to the role of lender of last resort - as the Fed was supposed to be in 1907 before the meddlers and micro-timers took over.
So let us have Hayek’s catallaxy of competing currencies, set by market forces. It must be an improvement.