Will liquidity boost worsen US debt woes?

Business Times - 14 Mar 2008

Will liquidity boost worsen US debt woes?

The Fed's latest bailout may create a moral danger by giving investors and consumers incentive to keep irresponsible habits


A FEW financial pundits speculated half-jokingly that the Dow's rise by 417.66 points earlier this week reflected the sense of relief among investors over the impending resignation of New York Governor Eliot Spitzer aka 'Wall Street's Sheriff,' who as a crusading former attorney-general had prosecuted many white-collar criminals in the financial community.

But in fact, the boost to the stock market, reflected in Dow's biggest one-day point gain since July 2002, came as a response to the surprising offer by the US Federal Reserve - coordinated with other central banks - to offer to lend through a 28-day-long auction up to US$200 billion of highly liquid Treasury securities to America's biggest banks and investment houses.

These financial institutions could use securities backed by mortgages as collateral for the Fed's loans. This was one aspect of the Fed's strategy aimed containing the growing credit crunch that seems to be gradually suffocating the entire United States economy.

'Pressures in some of these markets have recently increased again,' the Fed said in announcing its new measure to measure to pump more liquidity into the anxious financial markets. 'We all continue to work together and will take appropriate steps to address those liquidity pressures.'

Some economists are hoping that the latest action by the US central bank, described by many as 'complex' but 'creative', will just do the trick in terms of making it easier for the various economic players to lend and borrow money.

It was becoming obvious that previous moves by the Fed, including a series of interest rate cuts - the central bank is expected to cut rates again by a half a percentage point next week - have not helped to provide relief to investors and consumers from the credit squeeze.

If anything, the credit crunch seems to be extending beyond the mortgage industry - with foreclosures hitting an all-time high in the fourth quarter of last year - and is now making it more difficult for Americans to get even student loans or loans to finance their cars.

The credit crunch has been particularly a burden for homeowners, who in recent years had been enjoying higher standards of living than their financial circumstances would have otherwise allowed by frequently borrowing against their home equity.

These homeowners are finding themselves now with less cash to spend at a time when gas prices are rising to the stratosphere, making more likely that the economic downturn could end up more painful and longer. Moreover, the development is also posing a problem to politicians in Washington during this heated election year, since these financially-troubled homeowners are bound to express their frustration in the voting booth.

Hence, the hope in the White House and on Capitol Hill is that the dramatic move by Fed Chairman Ben Bernanke could help inject money into the financial system and make banks and other institutions feel less hesitant about extending loans.

But it's not clear that the Fed's policies are going to change the behaviour of the big banks that continue to be worried that the economy has yet to hit rock bottom and who are trying to raise capital as a way to strengthen their financial position in dealing with potential risks.

Indeed, the economic situation has only worsened in recent weeks, with more experts concluding that the US economy is already in a recession.

The value of the US dollar is continuing to decline while commodity prices, especially the oil price is climbing up, up and away.

And with non-farm employment falling by 63,000 in February as well as some troubling signs of inflation, it may not be surprising if even the most dramatic moves by the Fed - along with the economic stimulus package adopted by Congress (in the form of rebate cheques to consumers) - could have only a limited and short-term impact.

In fact, the decisions made in Washington are only creating a 'moral hazard' by helping to bail out investors and consumers and providing them with incentives to repeat their irresponsible behaviour of lending and spending like there is no tomorrow - instead of saving and investing. In the process, the value of the US dollar is dropping and this has ignited inflationary pressures.

Indeed, it might be argued that the painful developments that the government is trying to 'contain' - banks that fail, house prices that fall, credit that is less available - are actually the correct way to resolve the current financial crisis. The Fed and the rest of the government are displaying their customary tendency to over-react.

Many of remedies that are being promoted could end-up prolonging and worsening the crisis and perhaps even contributing to the next bubble.

Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.


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