Tue, Oct 14, 2008 - Page 9 News List

Cuts must come now before banks are ‘pushing on a string’

By Thomas Palley

Central banks around the world have finally reacted to the global financial crisis by engineering a coordinated half-point interest rate cut. That is welcome, but far more is needed – and quickly. If implemented now, steep rate cuts can still have a significant positive effect. If delayed, their effect is likely to be minimal.

Across the board, the world’s major central banks have been slow to respond to the deepening crisis. This failure reflects the dominance of conventional economics, which has led to closed-minded group-thinking within the global central banking community. As a result, central banks failed to see the oncoming financial tsunami and even after it arrived, they continued to fight the war against inflation.

The European Central Bank and the Bank of England have been the worst offenders. That is no surprise, as European central bankers are the most conventional in their thinking and have been the most obsessed with inflation. It also explains why continental Europe has had such high unemployment rates for so long.

The US Federal Reserve Board has done a much better job, though it too has moved in fits and starts, repeatedly playing catch-up with a crisis that has persistently remained one step ahead of policy. This pattern reflects the Fed’s own obsession with price stability, which encourages preemptive interest rate increases to head off inflation, but restrains equivalent preemptive reductions to head off unemployment.


Consequently, the Fed left its interest rate unchanged throughout the summer, despite the collapse of mortgage giants Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, American International Group’s insolvency and the emergence of global financial market contagion. Moreover, Fed policy remained constant despite rapid deterioration in the US’ real economy, indicated by accelerating job losses and rising unemployment.


The coordinated rate cut now undertaken by the world’s major central banks begins the process of policy catch-up, but further cuts are needed. Whereas the bogey of inflation seems finally to have been laid to rest, another myth must still be challenged – that the Fed and other central banks should save their “bullets” for a rainy day and should therefore resist cutting rates.

There is an old saying about monetary policy being useless in recession because the effect of lowering interest rates is like “pushing on a string.” That happens when confidence and wealth have been destroyed, at which point rate cuts do indeed become useless.

This is because the destruction of confidence undermines the “animal spirits” of capitalism — borrowers are unwilling to borrow and lenders are unwilling to lend. The destruction of wealth also destroys collateral, which means that even those who wish to borrow cannot. Meanwhile, insolvencies and foreclosures triggered by excessive interest burdens are not reversed.

By failing to act in a timely fashion, central banks have allowed a dangerous erosion of confidence and wealth, which is creating “pushing on a string” conditions. Fortunately, there is still time for decisive rate cuts now to have a robust impact. But the window of opportunity is closing fast. If central banks save their “rate cut” bullets for a later day, they may find that their ammunition is useless. The time to shoot is now.

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