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 on November 17, 2008 at Tomas Palley’s blog and reproduced here with the author’s permission.

3 Responses to "Cut Interest Rates Again"

  1. Guest   November 18, 2008 at 10:51 am

    As expected, the G-20 Economic Summit in Washington turned out to be a total bust. None of the problems which have pushed the global economy to the brink of disaster were resolved and none of the main players who gamed the system with their toxic securities were held accountable. Instead, the visiting dignitaries gorged themselves on stuffed quail and roast rack of lamb before settling on a toothless “Statement on Financial Markets” which accomplished absolutely nothing. The one noteworthy clause in the entire document is a two paragraph indictment of the United States as the perpetrator of the financial crisis. At least they got that right.The contagion started on Wall Street and that’s where the responsibility lies. It was the result of the Fed’s reckless low interest rates and lack of government oversight. This allowed market participants to create massive amounts of leverage via speculative bets on under-capitalized debt-instruments. The resulting collapse in value of all asset-classes across the spectrum has created a gigantic multi-trillion dollar capital hole in the global financial system which has precipitated violent swings in the stock markets, tightening credit, currency dislocations, soaring unemployment and deflation. Almost all of todays economic woes can be traced back to legislation that was promoted by key members of the Clinton and Bush administrations. (Many of who will now serve in the Obama White House) The G 20s statement puts the blame squarely where it belongs; on the Federal Reserve and Wall Street.