Financial crisis US central bank is utterly petrified

Larry Elliott

18 months on, US policymakers have turned to printing money. Convention has gone out the window.

During the decade leading up to the crash of 2007, some of us warned that excessive lending by reckless banks was an accident waiting to happen. We were told not to be so silly. The gods of the financial markets knew what they were doing.

When the global financial system seized up in August of that year, we said there was a risk of an economic pandemic that might plunge the world’s economy into a dangerous tailspin. This was greeted with derision. The system was robust, we were frequentlytold. Economies were well-placed to withstand any problems, we were told. The problem that seemed invincible would be contained because policymakers had matters in hand, we were assured.

All of which goes to show that Schopenhauer was bang on the money when he said that truth goes through three stages. In the first stage, it is ridiculed. In the second stage, it is violently opposed. And in the third stage, which of course is where we are now, it is accepted as self-evident.

Hindsight is a wonderful thing, but every policymaker now appears to accept that the global financial system was allowed to run out of control, and that the debt-fuelled expansion has resulted in an economic crisis of great magnitude that has affected countries in every part of the globe.

It is now accepted that the name of the game is damage limitation; to prevent what already threatens to be as severe a downturn as any in the postwar era turning into a second Great Depression. From every quarter of the globe, the recent economic news has been dire. Credit has dried up, global trade is at a standstill, and economies are shrinking fast.

The United Kingdom’s downturn entered a new and more dangerous phase with the news the other day that the jobless claimant count had burst through the one million barrier, with a 75,000 increase last month. The reality is that mass unemployment is coming back. The unemployment figures of a few days ago reflect what was happening to the economy six months or a year ago; it will be well into next year before the unemployment figures reflect the fact that the United Kingdom economy fell off the edge of a cliff this autumn. Desperate times call for desperate measures, so policymakers also take it as self-evident that the rules of the game have changed. In the United States, the Federal Reserve has dusted off emergency policies last used by Roosevelt in the 1930s because it is petrified that a slump is a very real threat.

Short-term interest rates have been cut virtually to zero, and the central bank has made it clear that it will leave them there for a long time to come.

But there is a recognition that the reluctance of banks to lend means cutting short-term rates is a blunt instrument - what JM Keynes, in The General Theory of Employment, Interest and Money, called pushing on a piece of string.

As a result, the Fed has also unveiled a series of so-called unconventional measures which, once you strip away the financial complexity and the economic jargon, amount to printing money in a bid to drive down the long-term borrowing costs for business and mortgage loans. Margaret Thatcher famously said: “You can’t buck the market”; the Fed is about to put that theory to the test.

Why is the Fed taking such drastic steps? The short answer is that for the past eighteen months the Fed’s conventional weapons have been firing blanks.

The United States economy is expected to contract at an annual rate of about 5 per cent in the final three months of this year, and a period of falling prices is seen as a real threat. When deflation was last allowed to embed itself in the 1930s it proved hard to budge, and the Fed is determined not to make the same mistake.

All things considered, this is probably the least bad option available, and similar action is being

carefully considered by the Bank of England.

The unconventional measures will have proved successful if they make mortgages more affordable and throw a lifeline to cash-strapped firms seeking to refinance themselves at a lower cost.

While no panacea, there is a chance that the recession in the United States will bottom out during the course of next year, with a slow recovery in 2010.

But hang on a minute, I hear you say:

isn’t there a risk that making borrowing cheaper will get us back in the same dreary speculative cycle that got us into this mess? Without the credit controls that buttressed the system in the 1930s, the answer is yes. There is a risk that the Fed’s manipulation merely substitutes a bubble in the bond market for a bubble in the housing market, and that like all the previous bubbles, this will collapse disastrously.

And there’s a risk that printing money leads to an inflationary surge in two or three years. The Fed knows all about these risks but thinks they are worth taking: that’s a measure of how utterly serious things are.