Stephen King: Radical measures needed to get us out of this terrifying game of Russian roulette
Monday, 17 March 2008
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They never wanted to play, and nor did they ever think they'd have to. Against their will, America's economic policymakers have become engaged in a terrifying game of Russian roulette. The US financial system is in danger of melting down. This may not be the most probable outcome. Equally, though, a bullet through the head is not the most likely ending to a game of Russian roulette. Unless you're mad, though, it's not a game you'd volunteer to play.
Friday's bail-out of Bear Stearns, the US investment bank, brought to a close a remarkably frenetic week in financial markets. Bear Stearns' president and chief executive, Alan Schwartz, said on Thursday "our balance sheet has not weakened at all. We don't see any pressure on our liquidity". A day, it seems, is a long time in financial markets.
The Bear Stearns rescue raises some really big questions. Until now it was possible to argue that, whereas the UK authorities had got things wrong, the US authorities had got things very right.
Northern Rock's collapse apparently stemmed from the Bank of England's failure to inject liquidity and its unwillingness to cut interest rates. It also stemmed from the Financial Services Authority's inability to find a buyer and the Government's failure to provide a bailout in times of distress. In contrast, the Federal Reserve did inject liquidity. It did cut interest rates. And the US does have bail-out options, not least deposit guarantees and the Federal Home Loan Banks (which effectively replaced the mortgage-backed securities market in the second half of last year).
While not all of these factors are directly relevant to the Bear Stearns situation, it seems that monetary easing, liquidity injections and the rest are in no way guarantees of financial stability.
This is a powerful, and worrying, conclusion. A few years ago, investors thought interest rate cuts worked. Back then, the Federal Reserve was typically rewarded for taking decisive action. During the dark days of 2001, for example, when the US equity market was in freefall and the economy was in recession, the dollar rallied, helped along by the sheer aggression of the Fed's monetary easing. The message was simple: the economy might have broken down, but the Federal Reserve knew how to fix it.
That optimism has gone, to be replaced by a growing scepticism. Interest rates have already fallen a long way in the US but there is, as yet, absolutely no sign of any beneficial effect. Indeed, it's as if financial investors have almost given up on America. In the early years of this decade, they gave the US economy the benefit of the doubt, replacing their earlier purchases of equities with investments in new-fangled mortgage-backed securities. These, though, were ultimately no more than loans to a housing market which has now turned to dust.
The Fed's latest rescue efforts have fallen on deaf ears. The dollar's value is plunging against virtually everything. The euro is now worth a remarkable $1.56. Sterling's weakness earlier in the year has partly reversed, rising through $2.02. Oil prices have reached $110 per barrel. Gold has hit $1,000/oz. And the yen temporarily jumped through the ¥100 level against the dollar.
The yen's strength is particularly astonishing. Japan's currency is, after all, controlled by a central bank which, on Wednesday, might find itself without a governor (Toshihiko Fukui is stepping down and Japan's politicians have been unable to agree on his replacement). The markets seem to prefer a rudderless yen to a dollar which is rapidly heading up the creek.
So what is to be done? It's important, first of all, to recognise that there is no quick-fix solution. We're witnessing a breakdown in trust within the financial system on a scale that doesn't lend itself toeasy answers.
Certainly, the policy initiatives announced so far haven't worked terribly well. In some cases, this is hardly surprising. Hank Paulson, the US Treasury Secretary, called last week for banks to raise more capital. But if this means a fire sale of assets, or a rights issue, this is hardly going to provide additional stability. Moreover, if the banks went down this route, their shareholders would presumably not be terribly happy. The best that can be hoped for is an injection of foreign public money, through the activities of sovereign wealth funds, but this approach contains its own controversies.
I think it's now time for some revolutionary initiatives. To my mind, three policy options need to be considered.
First, there has to be an immediate review – and possible suspension – of fair value accounting. This now-ubiquitous technique could be re-described as the tyranny of mark-to-market. If, for example, a bank made a loan yesterday at 5 per cent, yet the loan could be made today at 10 per cent, this is recorded as a loss. Mark-to-market measures the value of assets according to current market conditions, not according to the longer-term aims of borrowers and lenders. If, in the short-term, markets dive, mark-to-market leads to huge losses. These, in turn, contribute to the fire-sale of assets. It is a potential source of huge instability, and we're seeing its effects on almost a daily basis.
Second, central banks (and the governments which back them) need to do more than simply lend cash and liquid assets to the private sector. The Fed's announcement earlier in the week that it was prepared to lend Treasuries to a limited number of primary dealers in exchange for a wider range of collateral, including AAA-rated mortgage-backed securities, was seen by some as a magic bullet. It is no such thing. Ultimately, the authorities need to deal with the ongoing collapse in demand for an ever-widening range of financial assets and the obvious way to do that is to become buyers of last resort. This is, of course, highly controversial because it means that taxpayers will have to clear up the mess left behind by others. Better, though, to clear up a mess than be faced with a meltdown.
Third, it's time to think about so-called "helicopter money". While most people understandably worry primarily about the US housing market, the real threat to our economic security is now coming from the financial system. If this doesn't function, central bank rate cuts won't have much of an impact. Over the last few months, as banks increasingly have been forced to cut back on their lending, the power of the central banks has steadily waned.
Helicopter money bypasses the banking system. The government issues bonds directly to the central bank and the cash that's created can be placed directly in the pockets of households and companies through a series of tax cuts. The recipients, in turn, are then able to spend more easily, freed from the liquidity constraint imposed upon them by the banking system.
This is all controversial stuff. Accounting conventions are called into question. Taxpayers have to cough up. And the independence of central banks is at least temporarily undermined via helicopter money. Better, though, to get out of the Russian roulette game altogether than to end up with a bullet in your skull.
Stephen King is managing director of economics at HSBC
