Stephen King: It's time for the Fed to find a good plumber

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The Independent Online

Monetary policy normally works in the same way as your central heating system. You adjust the monetary thermostat – the policy rate – and wait for the economy either to warm up or cool down. Ben Bernanke and Mervyn King may be jolly clever men but their influence on the economy at large is not so different from your influence on the ambient temperature in your house.

Many of you will have experienced a failure of your central heating system from time to time. No matter how much you twiddle the dial on the thermostat, nothing seems to happen. At that point, you need to call in the plumber. The same is true in the world of monetary policy. Sometimes, changes in the policy rate fail to have the desired economic impact. Then, central banks start to fret. They, unlike you, don't always have the plumber's number to hand.

Put another way, the effect of changes in policy rates on the economy depends critically on the viability of the financial system. This is the economy's plumbing system. A well-functioning financial system makes a central bank's job easy. A poorly functioning systemis a headache.

Many people are puzzled about the Federal Reserve's decision to slash interest rates aggressively over the last few months. US inflation, after all, is above 4 per cent. In normal circumstances, rate cuts simply wouldn't be justified. We live, though, in unusual times. Ben Bernanke and his colleagues at the Fed have deliberately chosen to place the issue of inflation to one side. The Fed has only one ambition. It needs to fix the US economy's central heating system.

To understand what's gone wrong, you need to know something about securitisation. Securitisation is the process by which banks package up their loans, turn them into marketable pieces of paper, and then selling these pieces of paper to somebody else. For much of the current decade, securitisation boomed. Investors were happy to buy the banks' pieces of paper – typically known as asset-backed securities – because they offered better yields than government bonds and didn't seem to be as dangerous as equities.

For a while, these pieces of paper were treated a bit like money. The more pieces of paper the banks were able to sell, the more people they could lend to. And so long as the ratings agencies continued to claim the pieces of paper had some kind of intrinsic value, the underlying investors were happy. Lending boomed.

Unfortunately, lending quality deteriorated. In the second half of last year, investors (including the banks themselves) began to discover that the pieces of paper they'd previously bought, had suddenly lost their lustre. No one wanted to hold the stuff. This new-found revulsion meant banks could no longer lend – because they couldn't sell the paper.

The collapse of securitisation is gumming up the financial system. Without the ability to securitise, banks are having to find alternative sources of funds. That means higher deposit rates (good news for savers) but also, unfortunately, tougher standards for loans (bad news for homebuyers).

Others, who once thought they could easily get loans from banks, are having to think again. Companies, for example, are no longer keen on offering share buybacks or special dividends. Why give cash back to the shareholder when, with banks unwilling to lend and the possibility of a recession, you might need the cash yourself? So everyone is stuffing money under the mattress.

None of this is good news... and the story goes from bad to worse. During the earlier period of securitisation, too much money was chasing too few assets. House prices rose and, on the back of those gains, people borrowed even more. Now, we're seeing the flip side of this story. There's too little money chasing the available assets. House prices are falling... so banks will claw back their lending. In all likelihood, that means weaker consumer spending, slower economic growth and the very real possibility of recession.

Admittedly, we haven't felt the full blast of this chill wind in the UK. In the US, though, there's now a force 10 recessionary storm.

The housing market has been weak for a very long time, but now the collapse in securitisation has begun to bite. House prices are collapsing. In response, consumer confidence is in free fall. It's looking increasingly likely that consumer spending could actually contract this year, an outcome far worse than anything we saw during the last US recession in 2001.

Could the same happen in the UK? Increasingly, I fear it might. House prices are declining. Banks are driving up deposit rates. Credit conditions are tightening, notwithstanding rate cuts from the Bank of England. And the central bank remains focused on the control of the thermostat, and seemingly less concerned about the functioning of the financial system as a whole.

How do you get out of this mess? What is the monetary equivalent of a plumber? Fortunately, there are some workable options. If banks can no longer securitise, and hence no longer lend, why not get someone else to securitise on their behalf? Governments can borrow cheaply. Perhaps, then, they should raise funds which can then be lent to the banking system (indeed, the announcement from the US authorities last week that the government sponsored enterprises known as Fannie Mae and Freddie Mac would be allowed to buy bigger mortgages is a move in this direction). Alternatively, perhaps the government should bypass the banking system altogether, borrowing cheaply to put cash directly in people's hands through a range of tax cuts (again, a policy being adopted in the US).

Then there's the "helicopter money"option. If the collapse of securitisation has led to massive cash hoarding, why not flood the system with cash to reduced the incentive to hoard? This could be done via the government selling bonds directly to the central bank. The money then raised could be pushed into the economy via tax cuts.

That some of these options are under active consideration by the US authorities says something about the seriousness of the problem. Cutting interest rates is only one part of the solution and, in any case, is not likely to have much of an impact unless the rate cuts improve banks' profitability, which is far from obvious.

Still, at least there's an active debate about how to deal with the failure of the central heating system in the US, irrespective of the controversial nature of some of the options. In the UK, policymakers are in danger of fiddling with the thermostat while the financial plumbing system completely breaks down.

Stephen King is managing director of economics at HSBC stephen.king@hsbcib.com

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