One swallow doth not a summer make. Two summers of financial crisis, though, are enough to make the most robust of policymakers swallow hard. Last year, the spike in money market rates, the banks' loss of confidence in one another, the collapse of securitisation and, eventually, the nasty accident now known as Northern Rock were, collectively, fairly indigestible. Many investors hoped, though, that policymakers had enough firepower to deal with these problems. Interest rate cuts, they opined, would be enough to do the trick.
They were wrong on two counts. First, the collapse of securitisation has drained the lifeblood out of the banking system. Securitisation has turned into a modern day version of the Catholic Church's habit, back in the 15th and 16th Centuries, of selling indulgences to those, however sinful, who wanted their place in heaven. The difference, of course, is that investors back then only discovered whether their investments yielded a return in the hereafter whereas today's investors are nursing their losses in the here and now. Faced with this massive loss of confidence, monetary policy simply doesn't work very well, even with the liquidity injections that have taken place over the last few months.
Second, the scope for interest rate cuts has been severely curtailed by the unwelcome return of inflation. While most people fret about the effects on growth and employment of the financial crisis, there are plenty of officials – current and former – who sense that the world's policymakers have let the inflation genie out of the bottle. Having revealed its Max Mosley streak over the last few weeks, the European Central Bank is the exception. Frankly, though, Jean-Claude Trichet and his colleagues are only doing what central bankers are supposed to do, namely to raise interest rates in order to deliver price stability. M. Trichet, however, is currently in an enviable position. He's able to get out the monetary whip because, in the euro-zone, the signs of a sub-prime crisis are few and far between. Admittedly, there's a whole bunch of issues surrounding the "one-size-fits-all" approach to monetary policy, notably the worrying economic weakness in countries like Italy, Spain and Ireland. However, the European Central Bank isn't facing the difficulties now being experienced in the US.
Those difficulties are becoming worse by the minute. The so-called Government Sponsored Enterprises – Fannie Mae and Freddie Mac – are seemingly in deep trouble. Their share prices have tumbled, they are having to seek emergency funds from the Federal Reserve and Hank Paulson, the US Treasury Secretary, is in the process of negotiating a Congressional bail-out.
These are truly remarkable developments. To see why, let me quote some of the words describing its history on Fannie Mae's website: "Fannie Mae was created in 1938, under President Franklin D Roosevelt, at a time when millions of families could not become homeowners, or risked losing their homes, for lack of a consistent supply of mortgage funds across America. The government established Fannie Mae in order to expand the flow of mortgage funds in all communities, at all times, under all economic conditions, and to help lower the costs to buy a home".
In other words, Fannie Mae was set up towards the end of the 1930s to make sure that ordinary Americans would be able to obtain funding to buy houses against the background of the Great Depression, a period in history forever associated with massive unemployment and all-too-frequent commercial bank failures. If Fannie Mae itself fails what, pray tell, is the rescue plan for the US economy?
To be fair, what we're seeing currently is not – as yet – a failure on the grand scale. Fannie Mae was initially backed by the issuance of Treasuries and, hence, was a pure government agency. Over the years, however, it has gradually changed into a stockholder owned and managed "government-sponsored private corporation". This was enshrined within the 1968 Charter Act, which established a regulatory structure to ensure that Fannie would adhere to its public purpose even though it was privately owned. Behind all this, though, was the idea that, if the worst came to the worst, Fannie Mae and Freddie Mac might have to be bailed out with taxpayers' money. That, after all, is how Fannie Mae started off. And that is precisely what is about to happen.
There are, though, some obvious problems with the rescue of these mortgage behemoths. How much taxpayers' money will be left over to rescue other financial institutions should they, too, end up in trouble? The answer, presumably, is not a lot. It is for this reason that the share prices of many financial institutions dived last week.
If Fannie and Freddie are private corporations, why should they be able to jump to the front of the bail-out queue? The answer is simple expediency. The "too big to fail" doctrine utilised on so many previous occasions (Continental Illinois in the mid-1980s, Citibank in the early-1990s) applies to Fannie and Freddie more than any other US financial institution. As symbols not just of the American financial system but, more generally, of the American way of life, they take some beating. A collapse would be devastating.
If they are regulated so strictly, why is it that they now need bailing out at all? For me, this is a crucial issue. We have heard so often over the last 12 months that the financial system needs more, and better, regulation. Yet Fannie and Freddie were regulated, they were open to intense public scrutiny and they were required to act in the public interest. Despite all these safeguards, they're still in trouble. Regulation, then, is not the perfect answer to the world's many financial ills.
Messrs Bush, Paulson and Bernanke have, rightly, been keen to emphasise the role of the housing market in the current mess. Many financial institutions are in trouble because the value of housing, which ultimately provided the backing to huge issuance of mortgage-backed securities and other property-related financial assets, is tumbling fast. This, in turn, sets off a vicious circle whereby losses within the financial sector lead to greater restraints on lending and increasing foreclosures, both of which lead to further housing market weakness.
We are, then, living through a huge capital market failure. The earlier housing market excesses led to massive increases in lending which, in turn, led to even greater house price appreciation. Relative to people's incomes, house prices rose to ludicrously high levels. The collapse we're now seeing will probably take house prices down to ludicrously low levels.
While this will, eventually, be good news for those who, currently, are unable to get a toe on the property ladder, the collateral damage associated with the downward adjustment is proving to be very painful. Past experience suggests that, ultimately, no amount of interest rate cuts or currency depreciations, on their own, will lead to any kind of quick recovery, particularly when inflation limits the amount of monetary action that can be delivered. Inevitably, public funds – via ever-larger budget deficits – eventually have to be used to bring the capital markets as a whole to their senses. Japan, Sweden and Finland all had that experience in the early to mid-1990s and it looks as though both the US and the UK are heading in that direction now.
The bail-out of Fannie and Freddie is big news, but only serves to emphasise the wider point that, in financial crises, it is the (future) taxpayer who is left to pick up the bill.
Stephen King is managing director of economics at HSBCReuse content