“Adverse Self-Reinforcing Dynamic”: Financial Crisis May Make 1929 Look a “Walk in the Park”

December 25th, 2007

Some Christmas cheer from the Telegraph.

Via: Telegraph:

Twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meagre or fleeting effects.

As the credit paralysis stretches through its fifth month, a chorus of economists has begun to warn that the world’s central banks are fighting the wrong war, and perhaps risk a policy error of epochal proportions.

“Liquidity doesn’t do anything in this situation,” says Anna Schwartz, the doyenne of US monetarism and life-time student (with Milton Friedman) of the Great Depression.

“It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue,” she adds.

Lenders are hoarding the cash, shunning peers as if all were sub-prime lepers. Spreads on three-month Euribor and Libor – the interbank rates used to price contracts and Club Med mortgages – are stuck at 80 basis points even after the latest blitz. The monetary screw has tightened by default.

York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster.

“The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard,” he says.

“They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don’t think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park,” he adds.

The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. “We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other,” he says.

New York’s Federal Reserve chief Tim Geithner echoed the words, warning of an “adverse self-reinforcing dynamic”, banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails.

Section 13 (3) allows the Fed to take emergency action when banks become “unwilling or very reluctant to provide credit”. A vote by five governors can – in “exigent circumstances” – authorise the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.

Posted in Economy | Top Of Page

Leave a Reply

You must be logged in to post a comment.