By Lawrence Summers

Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers, the Fed has demonstrated a willingness to take on directly the most problematic parts of Bear Stearns’ balance sheet, and the Fed funds rate has been reduced by 200 basis points within 7 weeks.

At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac (the government-sponsored enterprises) to purchase more than an additional $300bn in mortgage-backed securities.

There is substantial scope for further regulatory action as only a third of the punitive capital charge placed on Fannie and Freddie years ago has been lifted. Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.

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By Martin Wolf 

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Joseph Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

Mine is not a judgment on whether the Fed was right to rescue Bear Stearns from bankruptcy. I do not know whether the risks justified the decisions not only to act as lender of last resort to an investment bank but to take credit risk on the Fed’s books. But the officials involved are serious people. They must have had reasons for their decisions. They can surely point to the dangers of the times – a crisis that Alan Greenspan, former chairman of the Federal Reserve, calls “the most wrenching since the end of the second world war” – and the role of Bear Stearns in these fragile markets.

Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Martin Wolf 

Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap.

Getting away with producing adulterated milk is hard; getting away with an investment strategy that adds no value is not. That was the point made by John Kay, in a superb column last week (this page, March 11). With the “right” fee structure mediocre investment managers may become rich as they ensure that their investors cease to remain so.

Two distinguished academics, Dean Foster at the Wharton School of the University of Pennsylvania and Peyton Young of Oxford university and the Brookings Institution, explain the point beautifully*. They start by asking us to consider a rare event – that the stock market will fall by 20 per cent over the next 12 months, for example. They assume, too, that the options market prices this risk correctly, say at one in 10. An option costs $0.1 and pays out $1.

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Alan Greenspan

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes - those belonging to builders and investors - have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will stabilise remains problematic.

The remainder of this column can be read here. Comment from our expert panel and guest members can be read below.

By Charles Wyplosz

In 1971, with the greenback weak and falling, US Treasury secretary John Connally famously told the rest of the world that the US dollar was “our currency and your problem”. Thirty years later, with the dollar strong and still rising, Robert Rubin, his successor, no less famously stated that “a strong dollar is in the interest of the United States”.

These days, because the dollar is weak and falling, we would have expected US officials to return to Connally’s mantra but they unexpectedly chose Rubin’s. On reflection, glorifying a strong dollar when it is so weak means they do not care. Connally without compassion, if you prefer.

Jean-Claude Trichet, president of the European Central Bank, is thereby left bemoaning “excessive exchange rate moves”. This, too, is an extraordinary statement. In the past week the dollar has barely lost 1 per cent vis a vis the euro. That is significant, but “excessive”? Yes, he may be reacting to the 6 per cent dollar depreciation in the past month. Or to the 17 per cent change over the past 12 months. Or perhaps the 31 per cent depreciation since the dollar was last strongish in late November 2005.

Well, currencies float. They are bound to be sometimes overvalued and sometimes undervalued. This is what they do and these numbers are not especially large by historical standards. Margaret Thatcher, former UK prime minister, was right when she said that exchange rates were a matter for markets to decide.

Of course, markets react to monetary policies. As the US economy faces a recession, a weak dollar is in the country’s interests. As inflation exceeds its own definition of price stability, a strong euro is in the interests of the eurozone. End of story? Not quite. (Continued)

Charles Wyplosz is professor of economics at the Graduate Institute of Geneva. The remainder of his column can be read here. Comment from our expert panel and guest members can be read below.

By Martin Wolf

What am I bid on financial sector losses from the US subprime mortgage crisis? Do I have advances on the $100bn suggested by Ben Bernanke, chairman of the Federal Reserve, only last July? Yes, I now have $500bn from the gentlemen from Goldman Sachs. Any advances on $500bn? Yes, I have $1,000bn-$2,000bn from Nouriel Roubini of New York University’s Stern School of Business. Any advances? Going, going, gone.

It is easy to be cynical about this ascending auction of scary prognoses. But we cannot ignore them.

In “Why Washington’s rescue cannot end the crisis story” (this page, February 27) I analysed the implications of aggregate financial sector losses of $1,000bn. That figure was in line with estimates by Prof Roubini and George Magnus of UBS.
I concluded that even this would be manageable, if painful, for an economy as big and a government as creditworthy as that of the US. Prof Roubini objects that I have taken the downside too lightly. He now argues that financial losses might amount to $3,000bn.

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Martin Wolf

Soaring commodity prices, rising headline inflation and weakening economic growth: for those whose memories stretch back to the 1970s, this combination brings painful memories. It reminds them of the mistakes made by the central banks that accommodated the upsurge in inflationary expectations rather than contained them. Inflation was finally brought back under control in the early 1980s. But the costs of letting it escape were huge. Could we be making the same mistakes again?

In the US, headline consumer price inflation was 4.3 per cent in the year to January. In the eurozone, it was 3.1 per cent in the year to December 2007. In both cases, there was a gap – in the case of the US, a huge gap – between the headline rate and the “core” rate, which strips out volatile prices of energy and food.

If this were a temporary deviation, one would ignore it. But it has been continuing for years, particularly in the US (see chart). A cynical observer might well conclude that the Federal Reserve threw caution to the wind years ago. That is what Arthur Burns, then Fed chairman, did in the early 1970s, under pressure from Richard Nixon, then president. Has that been happening again in recent years? The question is surely a fair one.

Continue reading Martin Wolf’s column here, and read comment from forum members and contributors below.

By Michael S Barr and Laura D Tyson

The US economy is caught in a vicious downward spiral of declining home prices, escalating foreclosures, rising losses on mortgage-backed securities, and disappearing liquidity. The liquidity crisis has spread rapidly from the mortgage market to engulf other forms of consumer credit, commercial real estate, and municipal and corporate debt.

Alarmed by the spectre of a prolonged economic slowdown, both the Federal Reserve and the US Congress have acted aggressively to stimulate demand through monetary and fiscal levers. The US Treasury has pressed mortgage holders to restructure mortgages and suspend foreclosures on a voluntary basis. But the continuing turmoil in financial markets confirms that these actions are not enough. Restoring confidence and liquidity in credit markets requires bold action to restructure the overhang of distressed assets and contain the losses in the US housing and mortgage markets.
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