December 2008

The blame for the ongoing financial crisis has been laid at the feet of many culprits: greedy bankers, ignorant investors, naïve borrowers, lax regulators, indifferent governments, incompetent rating agencies etc. Central banks have also come in for hefty criticism, largely because of an accommodative monetary stance in recent years that has significantly expanded the global money supply.

The resultant swell in liquidity is seen by many analysts as contributing to today’s crisis because it led, among other things, to the creation by investment bankers of the very securities (e.g. mortgage-backed bonds) whose collapse was the catalyst for the financial system’s current malaise.

Interest-rate policy is one of the most effective central bank tools for influencing economic behaviour. Broadly speaking, rates are lowered to stimulate economic activity and raised to limit activity and reduce inflation. But interest rates also dictate the price of money itself and therefore of credit, which in turn influences the degree of willingness to assume debt. One reason why central banks are so keen on monetary easing in the face of an economic slowdown is that lowering interest rates early is a time-honoured way of lessening the overall impact of recession or of a shock severe enough to depress economic activity, such as 9/11. This has been a mantra for central bankers since the Great Depression, which was exacerbated by the tighter monetary policies enforced in response to the 1929 market crash.

Nevertheless, the “demand-pull” inflation that monetary expansion implies will, if unchecked, lead to wage inflation, as industry competes for the services of a dwindling labour force, and asset-price inflation, as surplus money seeks a home in investments such as real estate or securities. So, given the large rate cuts already implemented, and the prospect of further significant cuts (perhaps even to zero), concerns that another liquidity bubble will occur in the future because of the expansionist policies now in force are understandable.

However, this need not be the case. The ongoing recession is not typical, due to the extra burden on the global economy caused by the financial crisis. Much of the liquidity that will be made available will go towards debt reduction, and consumer behaviour is likely to be more restrained than hitherto, even in the profligate US. Also, new legislation will probably enforce greater prudence in lending practices, with a reduction in the overall volume of outstanding credit, especially for consumers.

Such developments are clearly positive for the long-term health of an economy, but some analysts warn of Japan’s experience during the 1990s, when a prolonged recession resulted in a lengthy period of deflation, in which economic activity effectively came to a standstill and from which the Japanese economy has still not fully recovered. Less pessimistic observers believe these fears to be unfounded in the current circumstances because of the proactive policies now being pursued. Had the credit crunch been left to its own devices, the threat of deflation would arguably have been more ominous than it appears now. From that perspective, government intervention, through bailouts and fiscal stimulus packages, in conjunction with accommodative central bank initiatives, has been timely and will hopefully bear fruit before long. Until then, investors must be patient.