Monday, September 10, 2007


Current market crisis is Alan Greenspan's legacy

Current market crisis is Alan Greenspan's legacy

Business comment
by Richard Jeffrey
Last Updated: 12:40am BST 10/09/2007

Last week, the Bank of England took steps to ease some of the tension in the money markets. In explaining its action, it stated that "these measures are not intended, nor can be expected, to narrow the spreads between anticipated policy rates and the rates at which commercial banks can borrow from each other at longer maturities (for example, the 3-month interbank rate)".

In other words, it has no intention of taking action to force down medium-term lending rates, currently substantially above Bank Rate, or to bail out other banks and financial institutions that have made poor investment and lending decisions.

There is a temptation to assume that the current problems in the world's financial markets are merely the reflection of the impact that higher interest rates and slower growth in the US have had on the sub-prime market (and associated financial instruments). However, this is only the immediate cause. The real issue goes further back: why was there such huge sub-prime lending in the first place?

The financial markets hold central banks and bankers in great esteem. Most revered in recent times was Alan Greenspan, chairman of the US Federal Reserve between 1987 and 2006. He could move markets with an intake of breath and wrote his speeches, apparently, while soaking in a hot bath. He not only understood policy, but also had a deep empathy with financial markets. It seemed he could do no wrong.

Sadly, the current state of financial markets, and the problems facing some sectors of the US economy (most obviously the property sector) are Mr Greenspan's direct legacy. There were, of course, macro and financial concerns that prompted Mr Greenspan into setting the Fed Funds target rate at 3pc or less between September 2001 and June 2005 (and at just 1pc between June 2003 and June 2004). However, the policy response to the various issues amounted to a massive over-reaction (and appeasement of financial markets).

The UK authorities are not blameless. Here, there has also been a substantial rise in household indebtedness, encouraged by a policy regime that saw interest rates below 5pc between September 2001 and October 2006 and at 4pc or below between November 2001 and April 2004. In both the US and the UK, this inevitably sucked in large numbers of higher-risk borrowers. In the UK, a large part of the problem resulted from the policy framework set up by the Treasury. No one would deny that in normal circumstances low inflation is a sensible policy criterion. However, to make inflation the sole determinant of policy in a highly complex economy is inherently risky. The target itself is arbitrary, and structured according to how we perceive the economy has behaved in the past. It is not a range, as some believe, but a single point: 2pc. Although the Treasury can argue that the Bank of England's remit does give it a degree of flexibility, in practice current and forecast inflation dominates policy decisions.

Unfortunately, when the target was constructed, it was not envisaged there would be such substantial downwards pressure on the price level resulting from the opening up of China, India and other newly industrialising countries as major low-cost production centres. The result was the Bank of England's Monetary Policy Committee found itself more than once cutting interest rates with the express objective of forcing up the rate of inflation.

The consequence was domestic demand surged and house prices soared as households took on more and more debt. The most obvious symptom of what in earlier times would have been called overheating was an expanding trade deficit. Domestic demand grew much faster than the output potential of the economy, and the gap between exports and imports became the widest in our history.

Ironically, though headline measures of inflation looked satisfactory, it quickly became evident this was due to falling import prices. Domestically generated inflation did not fall, but remained considerably higher than the inflation target. What is more, it remains higher, and is a reminder we have not been as successful in reducing core inflation in the economy as headline numbers might indicate.

One indication of this is the inflation rate for all services products in the Consumer Price Index is running at 3.5pc (compared to an inflation target of 2pc). This is the same rate as has been recorded, on average, since the MPC was set up in 1997.

One of the greatest attractions of the inflation target is its simplicity. But that is also what makes it so dangerous. It has encouraged policymakers, economics commentators and financial markets to develop one-track minds, and ignore obvious signs that growth was becoming unbalanced. The implication was, if inflation was on target, all must be well. In reality, inflation should have been much lower between 1999 and 2005 - the UK would now be far more competitive, and have achieved far greater balance of growth in the economy.

Policy swings in Britain have not been as great as those in the US, and the problems that face us are of lesser magnitude. But the exceptionally high levels of household debt mean the UK could easily find itself in its own debt trap. Whereas in the US it seems the consequences will be confined largely to the financial markets, in the UK, the real economy could be much more vulnerable.

The naïve focus on inflation as the sole determinant of policy should be replaced by a broader remit that includes inflation. The objective should be to achieve a balanced, non-inflationary growth profile.

Richard Jeffrey is chief economist at Ingenious Securities

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