Cut Interest Rates Again

The recent massive sell-off in global stock markets, despite an earlier coordinated half-point interest rate reduction in the U.S. and Europe, reflects the continuing failure of policy to come to grips with the scale of the problem. Policy has been consistently marked by “Too little, too late” – and in some instances there have been outright blunders, as in the U.S. Treasury’s decision to let Lehman Brothers fail.

Given what is at stake, now is the time to err on the side of too much rather than too little. Confidence is critical in capitalist economies and once unraveled it is hard to stitch together again. Policymakers must therefore stop the unraveling in its tracks.

The G7 meeting brought official acknowledgement of need for governments to undertake coordinated radical actions, and it has been followed by specific measures to recapitalize banks in both the U.S. and Europe. Financial markets have responded with an enormous relief rally, but the reality is these measures will take significant time to repair the damage already done, during when markets will remain extremely vulnerable.

That points to need for central banks to implement a further immediate coordinated interest rate reduction, this time of a full point. This will consolidate the floor placed under markets, allow interest rates to catch up with economic reality, and buy critical time to implement fiscal measures aimed at strengthening real economic activity.

Whereas the recent decision to cut interest rates seems to have finally laid to rest the inflation bogey that has hindered policy, another myth still needs challenging. That myth is the Fed should save its “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 later rate cuts.

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. There is still time for decisive rate cuts 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 their ammunition is useless.

The time to shoot is now. An immediate large rate cut will reinforce actions already taken, strengthening the likelihood of success. If saved for later, rate cuts may be far less effective.

Originally published at Thomas Palley blog and reproduced here with the author’s permission.

5 Responses to "Cut Interest Rates Again"

  1. anton kleinschmidt   October 21, 2008 at 1:38 pm

    In my opinion the current crisis was brought about by a change in the dynamic of credit markets which has taken place over the past 20 odd years.About 15 / 20 years ago we started seeing a change in the way that banks managed credit. The old staid lending banker was viewed as a bit of an anachronism whilst the marketing types started gaining favour. Hardly any of the marketing types had lending skills. Many who were steeped in the traditions of good lending warned the new breed that they were playing with fire and that the aggressive marketing of lending products without good risk management was a very bad idea. Lending bankers all over the world were dismissed as ill informed Cassandras.The results are now there for all to see but the situation is complicated by the reality that many of the old lending bankers have retired and this is something of a triple whammy in that:1/ There are very few lending bankers left to clean up the mess created by the marketeers.2/ There are probably not enough trained experienced lending bankers in the industry to do the job properly in future.3/ Global banks realize what needs to be done but the do not have the skilled manpower to carry out the task of getting credit flowing again. No point in pouring government funding into the same black hole

  2. Guest   October 21, 2008 at 2:56 pm

    If trillions of bailout money across the world aren’t enough to restore sufficient confidence, what’s another 1% in interest rates really going to do?And if we get close to 0% in the US, won’t that in itself foment great concern, since everybody _knows_ the Fed has literally no ammunition left.We’re still only 1/3 into this recession at best.

  3. jkbland   October 21, 2008 at 5:08 pm

    I disagree. Artificially low interest rates and easy credit this decade caused the current crisis. Current rates are low on a historical standard and if these rates create excessive interest burdens, this indicates leverage that never should never have been assumed.I fear the cure that will prescribed for the disease of eccessive leverage will be more and cheaper leverage. At some point the adjustment to sustainable levels will take place. The question we must be able to answer is will the perceived short-term cure make us sicker in the long-term?

  4. Raquel S. Otis   October 22, 2008 at 11:54 am

    can someone tell me what will happen to the point if interest rates are lowerd in europe and uk and what will happen if there is no interest rate cut..thanks

  5. Raquel S. Otis   October 22, 2008 at 12:29 pm

    sorry i meant to say Pound not point