Sunday, December 07, 2008
Unconventional measures come to the fore
Posted by David Smith at 03:15 PM
Category: David Smith's other articles

When the Bank of England cut interest rates from 3% to 2% on Thursday, completing a three percentage point drop in the space of eight weeks, it underlined the gravity of the economic crisis.

Very weak business surveys suggested the downturn had “gathered pace”, the Bank of England’s monetary policy committee (MPC) said in a statement. And, “despite the actions taken to raise bank capital, ease funding and improve liquidity, conditions in money and credit markets remain extremely difficult”.

The key element in the statement, however, was that it was unlikely lending would get back to anything approaching normal without “further measures”. Cutting interest rates, even to the lowest level since Churchill was reelected prime minister in 1951, would not be enough.

Central banks are not yet singing from the same hymn sheet. Sweden’s Riksbank stung markets by cutting its interest rate from 3.75% to 2% hours before the Bank’s move.

But the European Central Bank confined itself to a 0.75 point reduction to 2.5%, and appeared to deny that the credit crunch was directly affecting the eurozone economy. Jean-Claude Trichet, its president, said that until the end of October at least “there were no significant indications of a drying-up in the availability of loans”.

Nobody believes that in America, or in Britain, which is why the Federal Reserve Board and the Bank have started to look beyond interest rates to those “further measures”.

Analysts believe, with the Fed likely to cut rates further later this month from an already very low 1%, it has already begun to take unconventional steps to try to slow the slide into recession.

Figures on Friday showed how big those dangers are. Non-farm jobs in the US fell by 533,000 last month, the biggest monthly drop since December 1974, when the world was gripped by the first big postwar recession.

Already, as well as cutting interest rates, the authorities in most countries have implemented, or are about to, big fiscal packages. The French president, Nicolas Sarkozy, unveiled a €26 billion (£22.5 billion) stimulus last week, mainly aimed at supporting businesses, hard on the heels of Alistair Darling’s £20 billion boost. Barack Obama, the US president-elect, is working on an emergency fiscal boost likely to be worth at least £300 billion.

Governments have also taken unconventional steps to bail out their banks, which in Britain includes £37 billion of taxpayer-funded recapitalisation, and £200 billion each of guarantees and liquidity.

Bank sources say it is this the MPC had in mind when talking about further measures; ensuring that the bank rescues are fully implemented and combining it with “moral persuasion” by politicians and central banks to force up levels of bank lending from their current crisis lows.

There is intense interest, however, in another tool in the central-banking box, so-called quantitative easing. When interest rates cannot go any lower and other measures have failed, central banks can try to force an increase in the money supply and therefore boost both economic activity and prices.

The technique, which some call printing money and others liken to a helicopter drop of cash on the economy, would not be attempted in normal circumstances. But when the risk is of prolonged recession and deflation, such action becomes justified. It was the strategy adopted by the Bank of Japan for five years from March 2001 when, under so-called “Rinban” operations, it tried to boost the money supply by buying up a range of financial securities. Economists are split about whether it was effective.

One eventual impact, Simon Derrick of BNY Mellon points out, was to weaken the yen, while higher food and energy prices may have played a bigger part in lifting Japan out of deflation.

If Japan provided a template for responding to a credit crisis, it did so in a slow-motion way.

Its problems started with the bursting of the so-called bubble economy in 1989, but its banking recapitalisation and rescues did not come until 1997-98, followed by the quantitative easing three years later. This time, things are happening much faster.

Last week Ben Bernanke, the Fed chairman, said he was considering buying up long-term Treasury securities and other instruments in the markets to boost the money supply through quantitative easing. His speech, which had a significant impact in the markets, may have been building on what the Fed is doing anyway.

“The Fed’s balance sheet has soared since September,” said Nick Stamenkovic of Ria Capital Markets. “It is effectively engaged in quantitative easing already.”

Graham Turner of GFC Economics thinks the Treasury is more open to unconventional remedies than the Bank. Officials at the Bank deny this, but play down suggestions that quantitative easing is imminent.

Should the Bank decide to, however, it would be very easy. The simplest method would be for it to buy up some of the gilts – Treasury bonds — issued by the government. Given the scale of issuance planned, there will be no shortage of opportunities to do so.

Could the government go further? Local authorities in Essex and Birmingham plan to raise funds and set up small-scale banks to lend to small businesses. State-owned regional banks are common in most European countries.

If the credit crunch persists, they could become common in Britain.

From The Sunday Times, December 7 2008