Another Look at the Consequences of Ill-Judged Central Banking.

Andrew Smithers.
Nikkei Veritas - Market Eye column, 7th December 2008

In my April article I discussed today’s problems, which derive from mistakes made during Alan Greenspan’s Chairmanship of the Federal Reserve. The key was his failure to take any action to discourage the excessively high valuations, initially of shares, and then of houses and other assets.

In the recent and precipitous decline in prices, US shares have become cheap for the first time since the early 1990s. As falling asset prices encourage savings and discourage investment, they reduce demand. Current declines are having a bigger negative impact on the economy than the positive one from cutting interest rates. The Federal Reserve has thus lost control of the US economy.

Past mistakes cannot be undone. A recession has already started in Japan, Europe and North America. There are several things that must be done to prevent this turning into a depression. First, there must be a strong fiscal stimulus in all major economies, including China and Japan. Second, interest rates must be brought down to near zero levels in the Eurozone, the UK and China, as well as in Japan and the US. Third, banks need further injections of capital, so that their assets can be written down to rock bottom levels and they can start to lend once again.

Household savings’ rates are about to rise in the UK and US. At present these are effectively zero and will rise as credit becomes restricted. A zero rate of savings for the whole sector is an average of the actions of its individual members, which means that the cautious have been saving part of their income, and the profligate spending an equal amount in excess of theirs. In the current crunch no new credit is available to the latter, who cannot therefore spend more than they earn. Meanwhile, the cautious continue to save, thus raising the average level of savings.

This will push down consumption in the UK and US and, at the same time, the fall in domestic demand will cause investment to be cut back. Without an offsetting rise in some other form of demand, this would lead to depression. The only way out is likely to be a boost to demand through tax cuts and higher public sector spending. But the UK and the US already have large external deficits, which they must reduce. They will want a large part of their increased savings to be used to cut their current account deficits and this will only be possible if regions with external surpluses like the Middle East and East Asia reduce theirs.

The Middle East is rapidly doing this due to the collapse in the oil price. China and Japan need to do their bit as well. In the case of Japan this is likely to require a much larger stimulus package than the one so far announced. Unfortunately the political calendar makes any additional measures unlikely before April next year. By then the necessity for a large additional cut should be even more obvious than it is today. China is also taking steps to boost its economy, but here also the severity of the problem is not yet realised and a lot more stimulus is needed.

Fiscal boosts are a necessary but not a sufficient condition for world recovery. In addition, banks must extend new loans and, to do this, they must be able as well as willing to do so. Banks cannot extend new loans without increasing the size of their balance sheets and they cannot do this unless they are increasing the amount of their equity capital. At the moment they lack the ability to lend, because they are not making enough profits. This problem will continue so long as the current value of banks’ assets is below their book values. A large additional write-off of banks’ assets is therefore needed and this cannot be done until further large additions to banks’ equity capital have been made. It seems likely that the major source of this money will have to be governments.

More tax cuts and more equity injections into bank capital are thus still needed. Even then it will take time for the economy of the world to recover. It seems unlikely that it will do so during 2009.