By Graham Turner
The markets have given their emphatic response to the banking bailouts put forward in the UK and US. Both rescue packages are flawed and will fail to stem the slide into not just recession, but possibly a global depression.
These bailouts were aimed at the symptoms, rather than the cause. Money markets are frozen because nobody knows how far property prices will slide, or the scale of losses banks will suffer. Banks are deemed insufficiently capitalised for the same reason.
The policy response of Western governments has, therefore, been back to front. If they solved the underlying problem – chronic property deflation on a scale not seen since the 1930s – liquidity will eventually return.
There is only one conventional policy that will work: deep interest rate cuts followed by a shift to quantitative easing.
Last week’s coordinated rate of just 0.5 per cent was token. Japan slashed its overnight rate to zero during its long economic downturn. If the US and UK want to get Libor rates to fall, then they should start by pushing overnight borrowing costs down to 0.0 per cent.
But, as we saw in Japan, that may well not be enough. The recapitalisation of banks in 1998 is often cited as a successful intervention that turned the corner for Japan. That is not true. The stock market did not hit its lows until April 2003.
The tide only turned when long term interest rates were pegged down at low levels too, with the Bank of Japan buying government debt. This is the essence of quantitative easing. The Ministry of Finance was also allowed by the US administration to intervene in the currency markets and drive the yen down.
Clearly the latter is not an option for the world economy. But driving down both short and long term rates is a far better policy weapon than the current stream of government initiatives, which will wreak havoc with the public sector finances.
Today’s partial recapitalisations of banks are not the answer because they will accelerate the slide into a debt trap. In the absence of radical monetary easing, the increased government borrowing to fund quasi nationalisations will ensure bond yields remain elevated. We are repeating many of the mistakes made by successive Japanese governments during the 1990s. They allowed the JGB curve to steepen and that delayed the much needed decline in borrowing costs. It would be better if governments in the West simply nationalised struggling banks outright. But even this still has to be funded through quantitative easing, otherwise, there will be classic crowding out as idenitified by Keynes.
Indeed, Japan saw its public sector debt burden soar from 65% to 175% of GDP between 1990 and 2005. This increase in public spending was not Keynesian. For much of this period before the BoJ started buying government debt aggressively, it caused bond yields to remain elevated relative to short rates. Lending rates did not fall quickly enough, and Japan became embedded in a cycle of debt deflation.
The US, UK, and many others are heading in the same direction. In Japan, property prices are still falling 18 years after the bubble burst. The Nikkei 225 has slumped 79% since the end of 1989. A commensurate collapse in asset prices across the rest of the Industrialised West will inflict grevious damage on savings, pensions and public services. Unemployment will rise remorselessly.
There is no guarantee that such a radical monetary policy will succeed. Central banks may have left it too late. Cutting the Fed funds target to 0% is necessary, but is unlikely to suffice. Driving the 30-year Treasury yield down to Japanese style levels, of 1% or so, may not be enough either.
Leaving it this late means the impact of these policies will be severely diluted. Monetary reflation only works if it is adopted in time. Had Japan cut interest rates and introduced quantitative easing much earlier during its long economic downturn, it could have avoided much of the deflation that scarred the nation.
However, the US and UK authorities should still act. Governments were slow to respond following the stock market tumble of 1929. Nevertheless, from 1932 onwards a Keynesian monetary policy did play its part in slowly turning the tide.
The UK has more room for manoeuvre. Short rates remain at penal levels, and the housing market has only been turning down for a year, compared to nearly three in the US.
But the risks remain huge. With one honourable exception, the MPC has unforgivably exaggerated the inflation risks. The FOMC has miscalculated too. Commodity prices are plunging. The reality of the emerging markets boom has been laid bare by the brutal sell-off seen over recent weeks. Much of their economic growth was not predicated on ‘globalisation’, but a surge in private domestic credit, in many cases, bigger than that seen in the West. So far, the downturn in the world economy has been driven by a retrenchment of the Western consumer. It will now be accelerated by a contraction of emerging market demand.
Inflation will drop like a stone over the next two years. It was never the predominant threat. Debt deflation has always been the more sinister curse. It is an ugly combination that can prove almost impossible to eradicate once central banks fall behind the curve, as they have done in the West.
Graham Turner of GFC Economics is author of “The Credit Crunch” (Pluto Press)