Stephen King: Central bankers ride to the rescue or is this Custer's Last Stand?

Policymakers preach the free-market credo but when the going gets tough, pragmatism takes over

I'm still not quite sure how best to describe last week's collective action from the Federal Reserve, the Bank of England and other major central banks. Did their decision to pump money into the global financial system represent the long-awaited heroic arrival of the Seventh Cavalry, a re-run of a 1950s cowboy movie? Or, less charitably, was this the equivalent of Custer's Last Stand, a failure which will leave the central banking community metaphorically scalped?

So far, the news is hardly encouraging. One pundit described last week's actions as "shock and awe", but this is not the most cheering of metaphors. After all, the "shock and awe" tactics used at the beginning of the campaign in Iraq didn't ultimately work quite as well as the generals had expected.

Indeed, if the aim of the central banks was to get the financial system working again, the policy so far has been a bit of a failure. Despite the offer of lots of additional cash, the lack of trust in money markets is still very much in place. On Friday, three-month interbank rates the rates at which banks lend to each other were still remarkably high. In the UK, they stood at 6.5 per cent, even though official interest rates are just 5.5 per cent. In the US, three-month interbank rates stood at 5.0 per cent, even after a Federal Reserve rate cut earlier in the week which took Fed funds down to just 4.25 per cent.

The gap between official interest rates and interbank rates is extraordinary. We've never before seen a gulf of this kind persisting for so long, despite cuts in official interest rates and frequent central bank injections of cash. And never before have we seen a money market fissure in so many different financial markets at the same time. Something is rotten in the state of financial markets, and central banks have yet to come up with a cure.

The medicine, though, is becoming more desperate. Central banks are now admitting that markets are failing. On Wednesday, the Federal Reserve announced that funds would be available to "all depository institutions that are judged to be in generally sound financial condition by their local Reserve Bank..." .... and not, by implication, by the market. In other words, banks which other banks refuse to lend to will be bailed out covertly by the central bank.

It's not difficult to see why the Federal Reserve has gone down this path. Following the Northern Rock fiasco, central banks know that another bank failure could spell disaster. So they need to find a way of supporting banks in difficulty without revealing the banks' problems to the markets and the public. That was the problem with existing arrangements. Having to go to the discount window for emergency funding, or tapping a central bank's lender of last resort facility, was a sure-fire way for an individual institution to reveal to everyone else that it might be in trouble.

I'm not sure, though, that the covert approach is much better. It rests on the idea that banks in trouble will always be saved by the central bank. But if some banks have business models that are in a state of collapse, the idea that an injection of liquidity is going to make all the difference is rather odd. If, in some cases, this is a crisis of solvency rather than of liquidity, a covert approach is simply going to delay the day of reckoning. Banks know this, and therefore may still be unwilling to lend to each other.

Market failures are being revealed in other areas too. US policymakers may preach the free market credo to anyone who cares to listen but, when the going gets tough, a flexible pragmatism takes over. During the US housing boom, finance for mortgages was provided through the issuance of "mortgage-backed securities", which were bought by investors all over the world. Through 2006 and at the beginning of 2007, around $600bn (297bn) of mortgage funds were raised on an annual basis through this market. In the third quarter, the amount had collapsed to just $14bn.

Yet the US economy is, for the time being, doing just fine, the result of a dirty little secret. The loss of funding from the collapse in mortgage-backed securities has been offset through an extraordinary leap in loans provided by the Federal Home Loan Banks. From virtually nothing in earlier quarters, these institutions provided almost $750bn in loans in the third quarter. The Federal Home Loan Banks are known as government-sponsored enterprises, quasi-public sector institutions ultimately backed by the taxpayer. In simple terms, then, while the debate in the UK surrounds the nationalisation of Northern Rock, the US has quietly gone ahead and nationalised its entire mortgage market.

So will the injection of a few tens of billions of dollars by the central banks make much of a difference? I think not. To understand why, cast your minds back to those extraordinary words uttered by Chuck Prince, erstwhile chief executive of Citibank, earlier in the year: "As long as the music is playing, you've got to get up and dance. We're still dancing." Now that Mr Prince has been forced to put his dancing shoes away, he presumably has time to contemplate precisely why the music stopped. And there is, I think, a simple answer.

Banks, answerable to their shareholders, find it very difficult to manage systemic risks (which, theoretically, are better dealt with by regulators). If other banks are in a profitable line of business, an individual bank has little choice other than to join in. A failure to join the party might lead to an underperforming share price and, eventually, a management shake-up. New executives, more adept at the financial quickstep, might then be brought in.

Once the party stops, however perhaps because one of the banking merrymakers gets into trouble managers at every institution have an opportunity to re-examine their business models. That, arguably, is what's happening now. The hoarding of liquidity is not just a story about a lack of willingness to lend to each other. It also may reflect a massive recalibration of business activities as managers collectively take the opportunity to get out of risky ventures. No amount of liquidity provided by the central banks is gong to persuade the commercial banks that mortgage-backed securities, for example, will once again be a major growth business.

If so, we're in for a rough ride. Economists often describe the provision by central banks of liquidity as "helicopter money", dropped into the economy from a great height. As the supply of money increases, so its value falls. People prefer to hold other assets or, alternatively, exchange money for goods and services. Either way, the economy supposedly receives a lift. But if other assets are falling in value even faster, there's no guarantee that the money dropped into the system will provide any degree of lubrication. You're merely left with the smell of economic napalm in the morning ... and noon and night.

The implosion within the financial system has partially severed the connection between central banks and the economy at large. Ultimately, helicopter money, on its own, is not likely to come to the rescue. A better option might be to create many more lower-risk lending opportunities. The most obvious way of doing so is for governments to issue a lot more bonds, and that, of course, means much bigger budget deficits. Perhaps it's time for John Maynard Keynes to make a comeback.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com