ANAGGING doubt is beginning to worm its way into the minds of finance ministers and central bankers as they survey the wreckage of 2008 and the worst financial firestorm for a generation: might all the policy interventions have made the fall-out far worse?
This crisis was sparked by growing doubts over the mountains of paper debt created on the back of record mortgage lending, first in America and then in the UK. It has been addressed so far by massive cuts in interest rates and desperate plans by governments to stimulate demand with reflationary packages. The first rewarded the over-borrowing. The second converted household debt into massive government deficits. So are the measures really cures – or panic reactions that result in a worsening of the problem?
It is telling that a year-long string of central bank rate cuts and government reaction has done little to boost confidence in markets. In fact in New York, London, Paris and Frankfurt, share prices are now some 40% lower than they were a year ago. And in the real economy confidence has slumped. It seems the lower that interest rates go, the less confidence there is.
Have we all been too mesmerised by comparisons to the 1930s Great Depression to over-respond in a way that has condemned us to a repetition? Have those comparisons warped our judgment? It is not just journalists and commentators who have invoked the 1929 Great Crash and its aftermath. Ben Bernanke, governor of the Federal Reserve, wrote a book on the Great Depression. Official pronouncements have aided and abetted the sense that we are in a repeat of those times – if not something worse.
A year ago, the hope was that the problems in the US housing market could be contained. But helped by successive interest rate cuts and a sharp fall in the dollar, the problems soon spread around the world.
Today is a scene of near total carnage. Japan's industrial output fell 3.1% in October. GDP growth in India is now at its slowest in four years and South Korea's industrial output fell 3% in October. Canada has gone into recession. In Germany the IFO business expectations index has dropped to a record low. Latest Euro zone unemployment figures have risen faster than anticipated, boosting expectations of a deep interest rate cut by the European Central Bank.
Amid the torrent of books and papers that will pour out in the wake of the 2008 Crash, one compelling counterfactual would be a blazing critique of policy blunders through the year. Allowing Lehman Brothers to go into bankruptcy is arguably one of them. Hank Paulson's mishandled and badly explained $700bn Troubled Assets Relief Plan (Tarp) another. But these errors could be excused as all too understandable given the apprehension and confusion of the hour.
More damning would be a critique that suggested policy response has been flawed from the outset. One such attack has been set out this weekend by Charles Dumas, economist with Professor Tim Congdon at Lombard Street Research. Comparison of the current economic and financial crisis to the 1930s, he believes, has led to wrong US policies, with needed remedies ignored.
"Mr Bernanke's long study of the Depression blinded him to the point that we are not in the 'bust' of a stock market bubble like 1929," Dumas writes. "Panicky slashing of interest rates a year ago was wrong: lower rates operate by encouraging more credit – just what was not needed. Instead, with Wall Street bulls still rampant, undermining the dollar led to bubbles in oil and food prices, which together contributed to a 2% rise in price inflation in the year to 2008Q3 – equivalent to a 2% global sales tax."
Dumas's argument is that household debt has to come down. Interest rate cuts do not contribute to this process of de-leveraging. The danger of fiscal stimulus packages is that, while they may help avoid a V-shaped trough at the onset of recession, they risk a W-shaped recovery as a modest bounce back is hit by the consequences of the debt incurred, by way of higher interest rates demanded by investors to cover the risk of soaring government debt.
The problem arose when Bernanke, faced with the prospect of huge likely defaults on US mortgages arising from excessive household borrowing, embarked on rate cuts late last year when the S&P 500 was trading close to current levels. The effect was to preserve the bullish mentality of markets that had produced the household debt bubble in the first place.
The result was that markets did not fall decisively through the 20% down level that constitutes a bear market until July. During this period Wall Street clung to a bullish denial of the need to stop running up household debt – up from around 45% of GDP to 100%. And cheaper money kept realisation among households at bay – like the "cure" of reviving an alcoholic with yet more whisky.
Can it really be true that all those silver bullets and super bazookas were fired with good intent, only to discover that they have made things worse?
Dumas's charge is that drastic, panicky US interest rate cuts a year ago caused a speculative surge of food and energy costs that added 2% to global inflation indices in the year to the third quarter of 2008. This acted like a sales tax, precipitating recession in the US, Europe and Japan. We do not face a crisis anything likes as severe as 1929-33, when real US GDP fell 26% in four years. In the severe recession of 1974-75 real US GDP fell by 3.1% from peak to trough. In the twin recessions of 1980 and 1982, the combined declines of GDP were around 3%. The recession now underway may (at worst), Dumas asserts, be of this order. Now in January comes an 'Obama Slammer' of a reflationary package, rumoured to be as high as $700bn. That should help the US economy in the immediate term and ensure it is first out of recession. But the debt catches up in the form of interest charges, and America may face a domestic backlash over its economy being funded by massive China loans.
'Real' recovery may be years off yet.