Central bankers cannot stop this contagion

By: Wolfgang Münchau

Since the start of the global financial crisis last August, monetary policy has been remarkably ineffective. The US Federal Reserve has cut short-term rates by a cumulative 225 basis points since then. Yet, borrowing costs for US consumers and companies have actually gone up. While the European Central Bank has stoically kept short-term interest rates at 4 per cent, rates charged to consumers and companies have increased.

So have bond spreads. On Friday, the spread between Italian and German government bonds widened to more than 70 basis points. In other words, the Italian government has been subject to an effective interest rate increase of more than 50 basis points during the past year, while the German government has not. While Italy has its share of problems, it is clearly no more likely to default today than it was a year ago. For as long as this financial crisis persists, interest rates will be determined by toxic market conditions, not central bankers. Among the various channels through which monetary policy affects the real economy, the credit channel is one of the most important. If real-world interest rates are determined independent of a central bank’s monetary policy, the effect of monetary policy on economic growth is correspondingly reduced.

But that does not mean monetary policy is irrelevant. On the contrary. It remains hugely important in steering inflationary expectations in the long run. I am not at all surprised by last week’s upward revision of the ECB’s own inflation forecast, a de facto acknowledgement that European interest rates have been too low for too long. Nor am I surprised by the falling yields of US Treasury inflation-protected securities, or TIPS. The difference in yields between ordinary US Treasuries and TIPS serve as an indicator – albeit imperfect – of future inflationary expectations, which are rising in the US as well.

We may even be in a situation where low interest rates give us the worst of all worlds: no stimulus in the short run, and a rise in inflationary expectations in the long run. What drives inflationary expectations up is not the current prices of oil or wheat, persistent though they may have been. What spooks investors is the loud and clear signal from central banks that they are not prepared to stabilise inflation in adverse circumstances.

This credit crisis is first and foremost a financial solvency crisis. When you are insolvent, the rate of interest is irrelevant because no one will lend you money in any case. And if someone did, the interest rate would still be irrelevant, since you are not going to pay them back. If you face only a liquidity problem, the rate of interest matters a great deal, since it determines the price you pay to regain liquidity.

This has not been a liquidity crisis, but a hugely contagious solvency crisis, affecting sector after sector, starting off with subprime mortgages, spilling over to the rest of the mortgage market, into municipal debt, corporate debt and many obscure sectors of the financial market.

A good example of how contagion works in practice came last week when Carlyle Capital defaulted on a margin call from its banks. What is happening here is known in financial jargon as “haircut contagion”.

In its September 2007 global stability report, the International Monetary Fund provided a useful hypothetical example of how a small fall in asset prices can easily wipe out an investor. Say, a fund invests $100 in a portfolio of risky securities. The margin requirement from the lender is 15 per cent. So on that basis, the fund borrows $85 from the bank. The rest is the fund’s equity. Assume the portfolio drops 5 per cent in value, and is now worth only $95. At that point, the fund faces a margin call. To meet it, it is forced to sell securities. When the bank decides to raise the margin requirement, or the “haircut”, more forced selling becomes necessary. At some point, the fund’s investors start to panic and get out. And the fund is forced to sell again. In this hypothetical IMF example, forced selling turned a portfolio of $100 into one of $36.

Interest rates do not even enter into the picture. Central banks could cut their short-term rates as much as they liked and they still would not be able to stop this kind of contagion. I cannot offer an effective solution either, and believe that this crisis will slowly spread from segment to segment of the credit market. It will spill over into the rest of the financial market and to the real economy. Perhaps there exist some regulatory devices one could deploy to mitigate the forced-selling problem. I suspect we will ultimately end up with some combination of regulatory relief, fiscal bail-outs, nationalisations and many, many bankruptcies of financial institutions not too big to fail.

But monetary policy itself cannot be an effective part of the solution of this credit crisis. This means that we are no longer living in the New Keynesian textbook world where the short-term interest rate is the variable through which central bankers can simultaneously control the economic cycle and maintain price stability in an optimal way.

A monetary policy overreaction would not solve any existing crises, but would create new ones. Nominal interest rates would rise sharply, bond prices would crash and a short financial crisis would become a long one.

Send your comments to munchau(at)eurointelligence.com

 

© The Financial Times Limited 2008

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