The Hindu Business Line : Govts may be Salvation

The global economy must be rescued from bankers. And bankers must be rescued from themselves. That just about might sum up a cynical view of the plight of governments and central banks as they struggle to deal with the worst crisis to hit economies and financial markets in recent times.

If only things were that simple. Mr Nouriel Roubini, one of the first economists to predict a housing-driven US recession as early as mid-2006, now thinks there is a significant chance of a severe financial meltdown.

The housing collapse has still some way to go, and will cause further losses to banks and investors in mortgage securitisations and soon spread to commercial property. These will be followed by defaults on credit cards and other forms of consumer credit.

Next will come the seizure of corporate credit markets. Stock prices obviously cannot escape. The combined effect of the huge damage to banks’ and investment portfolios, illiquid financial markets and credit withdrawal would be a ‘vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices’.

Scary scenario

It is a scary scenario, made all the more credible because of Mr Roubini’s prescience in calling the current weakness of the US economy.

But will governments and central banks remain bystanders if economies and markets go down under? Hardly likely. Growth will be top priority. Enough time to worry about inflation afterwards. The Fed Chairman, Mr Ben Bernanke, has said as much in his most recent communications.

Are rate cuts alone enough? The fear is that central banks will run out of ammunition if they do not quickly act to catalyse economies. The Fed, in particular, is vulnerable as its benchmark rate is already a low 3 per cent and there is little wiggle room on the downside. What if it doesn’t work is the big question. There is the none-too-comforting experience of Japan, where even prolonged zero interest rates failed to spark a sustained revival. Keynes ‘liquidity trap’, in which monetary policy loses its potency, is alive and well.

A viable recovery can emerge only if housing stabilises. Mr Bernanke must hope that low interest rates will put a floor on asset prices.

Writing on the wall

The writing is on the wall. It is not an issue of whether the government should intervene, but how much. President Bush and the Congress are already agreed on a $150-billion stimulus package. Staunch devotees of budget balancing have switched camps. Now the talk is of the Federal government taking over or guaranteeing the liabilities of housing borrowers in distress.

Mr Paul Krugman, another noted American economist, goes much further and advocates a public infrastructure investment and spending programme to restore consumer and business confidence.

Some problems are too big for central banks, as the current crisis. The votaries of minimalist government are on the defensive.

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