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US credit crunch – will history repeat itself?

IT was about two months ago on Sept 18 that the US Federal Reserve cut its short-term lending rate by 50 basis points to 4.75 per cent, sparking a worldwide rally in relieved stock markets. After a rise that lasted about two weeks, however, the rally then stalled. This was followed by a 25 basis point cut on Oct 30 but again, after a brief spike-up, markets have failed to respond.

Hopes are now high among analysts that the Fed will play saviour once again at its next meeting on Dec 11 – indeed, the futures market is certain that rates will be lowered again.

But given that the two cuts totalling 75 basis points have not provided the necessary stimulus yet, will more cuts really do the trick?

In his book, The Age of Turbulence, former Fed chairman Alan Greenspan wrote about the savings and loan (S&L) crisis of the late 1980s and the related property market crash that led to the closure of several banks and a recession in 1990-1992. The subsequent credit tightening meant that businesses found it hard to get loans and this, in turn, made the recession difficult to overcome.

‘Nothing we did at the Fed seemed to work,’ wrote Mr Greenspan. ‘We’d begun lowering interest rates well before the recession hit but the economy had stopped responding. Even though we lowered the fed funds rate no fewer than 23 times in the three-year period between July 1989 and July 1992, the recovery was one of the most sluggish on record.’

Those words must have an uncannily familiar ring to those who have tracked the current sub-prime crisis.

In its latest quarterly economic projections, for example, the Fed has cut its outlook for 2008 US economic growth to 1.8-2.5 per cent, down from 2.5-2.75 per cent. The downward revision stemmed from a number of factors, ‘including the tightened terms and reduced availability of sub-prime and jumbo mortgages, weaker-than-expected housing data, and rising oil prices’.

Worse, the situation today is potentially more damaging than during the S&L crisis because of the opacity surrounding the collateralised debt obligations market. Bad loans with questionable payment streams were embedded within complicated packages that were then marketed as being of good investment grade.

To further complicate the picture, derivative products are involved, which means the effect of a collapse could be magnified by leverage.

Investors – and central bankers – would therefore do well to note this insight from Mr Greenspan in his book: ‘Historically, societies that seek high levels of instant gratification and are willing to borrow against future incomes to achieve it have more often than not suffered inflation and stagnation.

‘ The economies of such societies tend to run larger government deficits financed with fiat money from a printing press . . . Eventually, the ensuing inflation leads to a recession or worse, often because central banks are forced to clamp down . . . I regret that the US may not be wholly immune to it.’

 

Source: Business Times 22 Nov 07

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