August 28, 2007 | posted by Michael Baxter in IABN |

In the world of global finance
there are no beginnings. To find the cause of a particular event, you always need to rewind the clock a little bit further - but to try and explain the crisis that fell upon financial markets this month, a good starting point might be the late ’90s, a time when Alan Greenspan was the head man at the US Federal Reserve, and the global economy suffered three major crises.

There was the East Asia crisis, the Russian crisis and the collapse of Long Term Credit Management (LTCM). On each occasion, many feared a major fallout, but Mr Greenspan leapt into action and would often react to market turbulence by lowering the rate of interest. This became known as the “Greenspan Put”, which is so named because it had the same desired effect as a put in the derivatives markets. A put enables investors to bet on a fall in the markets, so they can benefit from those negative conditions. The Greenspan Put meant that every time there were problems, the Fed would wade in and come to the rescue. So, markets could relax. They didn’t need to bet on the downside, because the Fed would ensure the downside never happened. It’s all very John Wayne.

But something else happened during this period. While the US and the rest of the developed world saw a form of Keynesian economics: boosting demand to deal with trouble, the developing world saw the opposite approach. The IMF imposed a fiscal straight jacket on the Tiger economies of the Far East and then Russia - enforcing years of hardship.

If you ever take the trouble to read the account of the saga written by former chief economist at the World Bank, Joseph Stiglitz, it’s enough to make the hairs stand up on your neck. Economies with massive potential capacity were forced to rein back demand, and maintain their currencies at high levels, while the US boosted demand even though capacity was near its optimum. It was back to front, and this month we saw the consequence.

But, don’t worry too much, because the solution is at hand. All that needs to happen is for Mr Greenspan’s successor, Ben Bernanke, to implement his own put.

He has already done it to an extent; on August 16 he reduced the US discount rate. Note: this is not the main US rate of interest that pundits follow and which relates to the level banks are supposed to lend to each other. The discount rate is the level at which the Fed lends money if it is called upon to act in its capacity of lender of last resort.

And with that move, markets picked up. Right now the Dow Jones index is 476 points up on the level before the rate of interest move.

So, Bernanke waves his magic wand and all is well. Phew. It’s thought he will try some more magic soon and, in a spell Harry Potter would be proud of, will scream out, “interestibus reductorum”. All those demons of the financial sector, the real life Voldemorts, will be dispelled.

The “Bernanke Put” we have already seen came in the wake of much pleading. In the US we saw this from captains of industry. For example, Ford CEO Alan Mulally said, “It is a really important job to manage inflation and economic growth, (but) focusing on economic growth appears to be a really important priority right now.”

But is the solution really that simple? The man called the Sage of Omaha, the Oracle of the investment world, Warren Buffet, talks about the US suffering from a massive hangover, the inevitable consequence of an almighty binge. The Fed appears to be dealing with the problem with some hair of the dog - like it has always done.

Is this the right approach? It depends on your view of recessions. Some think recession can be a good thing; they enable an economy to re-tune, to sort out the wheat from the chaff, and emerge lean, mean and ready to grow. Others see recessions as a wasted opportunity. Every time an economy grows by 1 per cent below historical average then we are all 1 per cent worse off than we could have been.

So, whether you believe the markets can be saved by expansionary monetary policy depends on whether you feel we are witnessing a hiccup, which central banks can soothe, or something more sinister, and that by reducing rates, central banks are merely dealing with the symptoms, enabling our behaviour to continue, and allowing us to hide from the true problems.

What is the true problem? The world is out of balance. The economies of China, Japan, Russia, South Korea, Taiwan, Singapore, India, Brazil, Malaysia and Thailand have massive levels of foreign reserves. They have learnt never to trust in the IMF again, they have learnt that the US will never give them a put, so they have gone the other way, keeping their currencies low. China is of course the key: with a staggering $1.3 trillion of reserves, roughly the same levels as Russia, South Korea, Taiwan, India, Brazil, Singapore, Malaysia and Thailand combined, and with the Chinese propensity to save, all that extra capacity from the developed world is not being matched by extra demand. But, given the way these countries have been treated in the past, you can’t blame them. As for China, it has learnt from the mistakes its neighbours made.

And so, we import cheap products from the developing world, but to a large extent we don’t pay for them - we are loaned the money to buy these products. China’s policy of keeping the yuan down means we are in effect being offered hire purchase terms, but at rock bottom rates, repayable over an extended time frame.

So, low inflation thanks to cheap imports means a low rate of interest. Money flooding into the shores of the US and Europe from the developing world means there has been plenty of credit. The carry trade, in which people borrow in Japan where rates are so low, and lend elsewhere, has boosted credit and then there’s all those Fed puts following events such as the East Asia crisis, Russia, LTCM, the dot com crash, 9/11, Enron and WorldCom. Essentially, the Fed’s response has left us with lax monetary conditions.

While all this was happening, finance got very sophisticated. We saw the emergence of syndicated debt - CDOs, in which bonds carry all kinds of debt, from sub prime mortgages to corporate financing, and no one seemed to understand what was happening, who owned what. If we are being kind we could say the ratings agencies didn’t get it and wrongly gave bonds AAA credit status; others are more cynical and say the credit agencies gave out these treble A ratings because they were working for the very companies who were selling the bonds - shades of Arthur Andersen and Enron.

But the complexity of the CDOs carries its own danger. This month markets and banks panicked because no one seemed to know quite how much danger they were in.

Whatever the specifics of the market falls, which we will describe below, the root cause is this. There was too much debt and too much available credit, caused in part by interest rates that were forced down to try and soften a series of crises. Combine this with developing countries refusing to be drawn into the US way of doing things, like they once were, and the problem becomes clear.

The danger is this: every time the Fed and other central banks implement a solution that involves lowering the rate of interest, they simply reinforce the underlying problem.
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