Why does it linger?

The Economist brings out a brilliant analysis of why the liquidity crunch refuses to die down.

It’s a long article. Here is my synopsis –

The double shock of decline in house prices and the sudden slump in prices of ABS have come at a time when the global economy is also witnessing a surge in commodity prices. This limits the power of the central banks to cut interest rates as it could stoke inflation further up.

The double shock entails uncertain direction of monetary and regulatory policy. When inflation targets are revised upwards, central banks will crack down so hard on inflation pushing the economies into recession. Further the effect of investment bank rescues will let in a harsh new regulatory regime that will stifle credit and hence future growth.

Then it is the nature of the previous boom fueled by indiscriminate borrowing by people to buy houses that they couldn’t clearly afford hoping to cash in on capital gains and investors buying complex high yield debt products they hardly understood. Both the lenders and investors were beholden to banks and that former wellhead of finance has now run fairly dry. In turn, that explains the absence of bargain hunters, particularly in the debt markets.

Investment-grade debt might look attractive on a five-year view, if all you have to worry about is the risk of default. But most investors in that market have a three- or six-month view; they cannot afford for things to get worse before they get better, in case they are forced into a fire-sale of their assets.

"So the markets (and the developed economies) are waiting for a catalyst for recovery. Lower commodity prices helped for a while, and may help further if they encourage central banks to cut rates. Evidence of a bottom in the American housing market may also do the trick. But the crisis seems certain to linger into 2009, and could even make it into the following year. Successful horror movies tend, after all, to have several sequels."

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Life ain't easy for central bankers

The primary role of a central bank in a modern advanced economy is to set the price of money – the interest rate. Large commercial banks are generally compelled to hold a certain proportion of assets at the central bank and in return receive risk-free central bank money, the equivalent of large bundles of notes and coins.

What’s the big deal…? I ask.

All the major central banks are now beset by the issue of “moral hazard” – the concern that their actions in offsetting market turmoil might prompt investors to take even bigger risks in future, with potentially catastrophic consequences.

In a crisis, central banks have enormous firepower to drown financial institutions in cash. But if they throw money at a crisis, they face two risks.

First, they send the overnight interest rate tumbling because banks have too much cash and all try to lend it out. Inflation follows. Second, they send the signal they are always ready to bail out banks and encourage riskier practices in future.

Choose your devil. Easier said.

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Should we grudge the central banks?

I hear a lot more arguments against the central bank policies that inflate money supplies and its support to artificially-cheap credit that provides the fuel for speculative fever and instability.

On one hand, a liquidity crunch inspired sharp declines on many of the largest stock exchanges around the world. On the other hand, the Fed, the European Central Bank and the Bank of Japan pumped in liquidity worth hundreds of billions of dollars. Their idea was to restore calm by providing the means for borrowers to meet short-term credit needs. I have discussed it here earlier.

It may seem counter-intuitive but the good news was that the credit crunch was a signal that air was being released from stock market bubbles. It was a welcome event that excess liquidity behind most imbalances in the global economy was finally retreating. Interest rates are the single-most important conveyor of information — with these artificially low, investors felt their wealth had risen and got reckless.

Hey, but wait a minute… Central Banks intervention has as much to do with politics as it has to do with economics. When large number of people reel under debt mountains, someone has to help them ease the load. When Central Banks quietly ignore a subprime lending that overlooks all norms of credit assessments and individual’s capacity to repay debt, they’ve already precipitated a crisis – first sin. Now when it recoils, you grudge the central banks for infusing liquidity – the second. We're talking about lives here in millions - not just what makes good economics. Either you don’t commit the first sin or go cool with the second... can’t have it both ways. What do you think?