BROKE COUNTRY WITH LAVISH INTENTIONS

A few hours after a surprising change in power, the World Bank issued a country report in which it warned the incoming Government of the massive gaps in the finances of the country. the theme and the message of the report was that Ghana was broke! This was in contrast to a report barely 3 months ago in which the same institution praised government on its economic management performance and how it had done extremely well in the face difficult external circumstances. But a in a twist that surprises no one but equally abhors everyone

Is monetary policy still a potent weapon against recession?

Is monetary policy still a potent weapon against recession? WRITING in Slate magazine in 1997, Paul Krugman, an American economist, neatly captured the widespread belief in the omnipotence of the then-chairman of the Federal Reserve. “If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” Faith in the Federal Reserve is not what it used to be. Since September the Fed has cut its policy rate by 1.75 percentage points, to 3.5%. It still has plenty of firepower left—rates are some way above the 1% level reached in 2003—but few seem willing to rely on monetary policy alone to save the day. Politicians and pundits alike were making a case for a fiscal stimulus package even before the Fed's surprise rate cut on January 22nd. That Ben Bernanke, the Fed chairman today, has given his blessing to the plan only adds to the impression that central banks have lost their grip. What lies behind this loss of faith? One cause is the feeling that overly loose monetary policy got the economy into this mess. Repeated cuts in interest rates during the last downturn, in 2001-03, fuelled the housing and credit bubbles that are now bursting to such damaging effect. The legacies of that boom—falling asset prices, high consumer debt and bank losses—may now hamper the ability of central banks to prop up spending. One of the ways that central banks affect the economy is through their influence on the price of assets, like shares or homes. Other things being equal, a reduction in short-term interest rates should bump up asset values, because their stream of future earnings is discounted by a smaller factor. Now that America's housing boom is ending, the worry is that the Fed is less able to stimulate the spending that comes with rising housing wealth. Assets are already dear, it is said; there are no bubbles left to reflate. Falling home prices make for a nation of savers, not shoppers. And firms are not keen to invest when the market value of their assets is shrinking. Falling asset prices hurt the market for credit too, interfering with another policy channel. Monetary policy affects the choice between spending now or spending later and, for the cash-strapped, credit provides the bridge from the present to the future. Interest rates are the cost of using tomorrow's income to pay for today's spending. Lower rates lift spending by more when there is access to borrowing. Firms and homeowners can borrow cheaply with good collateral, but funds are less abundant when asset values are falling. Consumers may in any case have had their fill of borrowing. Household debt in America has vaulted to more than 130% of disposable income from less than 100% in 2000 (see left-hand chart). In Britain the ratio is higher still. And even if credit demand holds up, banks reeling from subprime-related losses are less willing to supply it. Another strain of policy pessimism argues that interest-rate cuts will only fuel inflation, without helping the economy. In fact it seems likely that America's economic slowdown will create enough slack to ease inflationary pressure. That, at any rate, seems to be the judgment of the bond markets. In the months since the Fed's first rate cut in September, ten-year bond yields have dropped steadily, in contrast to the reaction to the rate cuts in early 2001, when bond yields drifted upwards (see right-hand chart). The distant sound of whirring rotors Central banks are not toothless, however. They can still affect spending by altering the returns of existing savers and borrowers. Lower interest rates increase the disposable income of debtors, by cutting their repayments, even as they eat into savers' cashflow. Borrowers are likely to spend more out of each additional dollar, so tilting the scales in their favour by cutting rates should boost demand. In America the household sector's debt has grown faster than its stock of interest-bearing assets, so the cashflow channel is now likely to be more, not less, powerful. The effect is probably stronger still in countries such as Britain and Spain, where most mortgage rates are closely tied to policy rates or fixed for only short periods. Although the asset-price and credit channels are more constricted than in the past, monetary policy can still work through them. Interest-rate cuts are unlikely to lift house prices, but they may at least arrest the size and pace of price falls. The firms and households that are less burdened by debt will be able to take advantage of lower interest rates, even as others are struggling to reduce their borrowing. If the Fed still has some clout, why the clamour for fiscal stimulus? In an election year, politics is one obvious factor, but economic arguments can also be brought to bear. One attraction is that it eases the over-reliance on monetary policy. Alan Blinder, a Princeton professor and former Fed governor, also argues* that fiscal remedies can boost demand more quickly than interest-rate cuts. Tax breaks work well if they bring spending forward, say by targeting help on the poor, who are more likely to spend than save—though this may be hard to arrange in practice. The drawback is that it leaves decisions to politicians, who risk taking too long to agree on the right policies in a slump and are unwilling to raise taxes in a boom. Although monetary policy is normally best placed to help stabilise the economy, there are some circumstances where fiscal policy can help—during long or deep recessions, when demand suddenly slumps, or when interest rates fall to zero. In the latter case, writes Mr Blinder, “a combined monetary-fiscal effort—deficit spending or tax cuts financed by printing money—may be needed”. This is Milton Friedman's “helicopter drop” of money. Only then will the Fed really start to feel impotent.

Rethinking global financial systems

Rethinking global financial systems

The consensus is loud and clear: in the wake of the worst global financial crisis since the Great Depression, a fundamental rethink of the structure of the global financial markets and greater cooperation of the major regulatory bodies are paramount, said the heads of major financial institutions at the World Knowledge Forum in Seoul.

And ahead of a meeting of the G20 nations in mid-November to discuss financial reforms, leaders from the 45 member nations of the Asia Europe Meeting (ASEM) have pledged to cooperate in overhauling the world’s financial systems and called on the International Monetary Fund (IMF) to ‘play a critical role’ in assisting countries most in need of aid.

At least five countries have reportedly sought the help of the IMF in injecting capital into their economies. The IMF, which has agreed to lend Ukraine $16.5 billion to ease the impact of the financial crisis, is also lending $2 billion to Iceland. Meanwhile, Hungary is reportedly close to securing a ‘substantial financial package’ from the IMF and the European Union.

Speaking at the World Knowledge Forum, Douglas Feagin, head of Goldman Sachs’

financial institutions group for Asia, believes that reforms of the financial services sector

are crucial in restarting economic growth in the US, Europe and the rest of the world.

Pointing to the bubbles in key asset classes, “unclearly unsustainable” leveraging in the financial systems, and poorly understood and managed derivative securities, Feagin says: “We are going to have to have a change across all these areas – the asset price bubbles, deleveraging and reform of the fundamental securities markets – in order to have a basis to restart economic growth.”

Meanwhile, fears of a global recession continue to weigh heavily on financial markets around the world, even as many individual countries – such as Australia, Japan, South Korea, Singapore, Kuwait and Saudi Arabia – have announced new financial and regulatory measures to shore up their financial systems and currencies, and boost confidence.

Governments around the world have so far reportedly pledged about $4 trillion to bolster banks and restart money markets. China, South Korea, Japan and ten Southeast Asian countries have also pledged to create an $80 billion fund to combat currency speculation.

“I think we are going to see for the first time a private-public sector partnership and a

globally coordinated attack on some of the underlying weaknesses in our global economy,” says Steve Ellis, worldwide managing director of consultancy Bain & Company.

“If we continue to act as the really globalised economy we are today, and if we maintain that tight linkage between public and private sector in ways that can reinforce the flow of capital, that can hopefully reinforce economic growth and address some of the very pressing issues facing our planet, I think we could look back on this as a real catalyst.”

While there appeared to be consensus among the speakers at the Forum that comprehensive reforms of the global financial systems are needed, opinion was split between some calling for a universal financial regulatory body and those supporting closer and greater cooperation between the major regulatory bodies around the world.

Sir Leon Brittan, vice chairman of UBS Investment Bank, expressed scepticism about

former Irish prime minister Bertie Ahern’s suggestion about the creation of such a universal regulatory body. Brittan, a former vice president of the European Commission, says he doubts this would be a “correct solution” given the presence of the IMF and the World Bank, as well as the protracted length of time needed and the significant challenges in creating such a regulatory body.

Brittan says a ‘more promising avenue’ would be a “college of regulators – and not a new super regulator – which would work closely together, with detailed regulations being applied in each individual country.”

“Cooperation between international regulators on a greater scale – even though it is already taking place and one shouldn’t underestimate the extent to which it is already happening – is something that is going to be important.”

Agreeing with Brittan, Jeffrey Shafer, vice chairman of global banking at Citigroup, criticised calls for “a universal global body with no direct democratic accountability” as an “ivory tower fantasy” and “a diversion of energy”.

Shafer, a former Under Secretary of the US Treasury, favours a focus in the US on regulatory functions rather than just on individual institutions. Regulatory bodies, he says, are needed to look into systemic risks and the activities of individual financial institutions.

“You need to give that systemic institution the power to intervene and actually make individual institutions do things when they see large imbalances emerging in the world, and that will be a tough thing to get into the regulation at the end of the day,” says Shafer.

To be sure, overhauling the financial regulatory frameworks around the world is a dicey proposition because while bad regulations can create crises, it’s not certain that good regulations can prevent them, cautions Paul Tregidgo, a vice chairman of the investment banking division of Credit Suisse.

The fundamental issue “right at the centre of the (financial) storm” lies in how risks are created, assessed, distributed and regulated, which are regulatory questions that must be addressed, says Tregidgo.

“Do we actually know when we create risk what we are creating? … When we assess risk, are we actually assessing risk in a world of global connectivity? Do we understand the cost and price of risk as it should relate to other instruments?”

“Do we understand that when it is subject to stresses which we have not experienced before, and lastly when we distribute risk, are we really distributing it?”

Tregidgo adds there is a need for closer regulatory oversight of how major financial intermediaries approach, assess and price risks.

“It’s time for a new regulatory contract but that regulatory contract, broadly speaking, must balance the complexity and connectivity of which I spoke earlier,”

“I would suggest minimal regulation but forceful in letter and spirit because innovation … is not going to go away and must be encouraged to flourish. But innovation cannot be allowed to game the system.“

Certainly, there are mixed views about how best to balance regulatory oversight and allowing room for financial innovation to spur economic growth. But for the next few years, ‘de-structuring’ or structural changes to banks and financial institutions will be a theme, says Michael Gordon, global head of institutional investments at fund manager Fidelity International.

“Regulation is going to have a goal of trying to get us to a more simple financial world,” says Gordon. “We may look forward to a world where banks are more like banks as we used to know them, brokers more like brokers, corporate finance returns as a function of itself, asset managers being pure asset managers and the like,”

“I think we will see a trend back to simplicity away from complexity. I think financial modelling will be less trusted.”

For now, the concerted efforts of central banks and major financial institutions around the world to inject liquidity to resolve the global credit seizure are working, says Goldman Sach’s Feagin.

“We are now seeing people starting to be comfortable opening up the markets again,”

“I think we have seen some pretty dramatic steps and some pretty positive steps but a huge uncertainty remains, and this is going to take many years to get fully resolved.”