Ben's depression

By: Wolfgang Münchau

The pattern is always the same. When the Fed cuts interest rates, investors pile into the markets, pushing up share prices for a few hours. It takes then only a few hours until some other scare story comes up, and the whole process goes into reverse. US shares shot up following the Fed's announcement. This was followed by a mini-rally in Asia, but back in Europe, we are down again on  rumours that Royal Bank of Scotland may be in trouble. That rumours is almost certainly false, or at best self-fulfilling. If HBOS was not in trouble, it may be now. In any case, monetary policy has no noticeable effects on equity markets. Their dynamics is driven by fear.

 

A monetary policy geared towards stabilising equity markets, which appears to be what the Fed is doing, is ultimately futile. Stock prices are discounted values of future earnings, and the decline in the market reflects two related issues - the rise in the probability of huge tail risk in the form an escalating financial crisis is and the expectation of a deep recession. Unless the Fed's policy action can convince market participants that low interest rates will alleviate one or both problems, a rate cut is not going to do anything. And if the Fed cuts too much and produces inflation, long-term interest are certain to rise. This would increase the tail risk of a systemic collapse of the financial system and prolong the recession. In other words, if you cut interest rate too much, stock prices may actually fall. In other words: Interest rate cuts could cut both ways.

 

The correct policy response would be a combination of generous liquidity provision (though no bailout of prime brokers), nominal interest rates set at a level that is commensurate with price stability (about 4-5% in the US, not 2.25%), and punitive bailouts of ailing financial institutions. Those fiscal bailouts need to be structured in such a way that the public maximises its long-term risk-weighted returns at the expense of financial industry shareholders and stakeholders. In other words: if we bail out bank X for $10bn, then we do in such a way, that the bank's shareholders and employees will transfer back to the public the financial aid granted plus interest at some punitive rate over a number of years. Parts of the financial system would be forcibly nationalised, and re-privatised at a profit later. It would also be right to impose a special tax on financial institutions and their employees in the form of punitive taxes on wages, and earnings.

 

The wrong policy response is trying to avoid a recession at all costs. This is not only because it delays the day of reckoning, as it is so often put. The real problem is that such a policy might unleash a catastrophic dynamism. The Great Depression of the 1930 ended swiftly once monetary policy started to target price stability again. In our case, it will be the other way round. Once the Fed is forced back on a path of targeting price stability, our Great Depression will begin. The recession could turn into a depression precisely because monetary policy set out to avoid the recession in the first place.

 

 

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