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'Knee-jerk' response to crisis increases danger

Friday, October 17, 2008

'Knee-jerk' response to crisis only increases danger

By Ben Jacobsen

Both Labour and National are using the current financial crisis for short-term political gain. Just like in the United States, proper action seems to interfere with knee-jerk responses along traditional party lines. The US example shows how dangerous that is.

We are in a state of financial turmoil when the Dow Jones – the world’s most famous stock market index – can gain or lose 1000 points during just a commercial break. Contrary to the US and Europe, the waves of this financial mega tsunami have not reached our shores yet.

The responses of the US and Europe have been completely different. Europe has responded decisively and fast with all the proper actions. Rather than buying bad loans with only downside potential European governments have immediately nationalized or taken large stakes in banks so that their citizens might profit from any upside.

They provided liquidity when the market asked for liquidity. They offered deposit insurance when "bank runs" needed preventing. When investors asked for global commitment to fight the crisis they collectively dropped the interest rate.

In their last collective action they guaranteed inter bank lending when the market needed trust. That action took markets away from the abyss that was looming. And last but not least, when – surprisingly – many Europeans underestimated the risk that their savings accounts might be frozen in Iceland, European countries came to the rescue of a country. This is crisis management at speed, which one would not normally associate with politicians. It seems that Europe has learned from the Swedish banking crisis in the nineties.

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The US, on the other hand, let Lehman Brothers fail, which added to the global uncertainty. And at best, after the $700 billion action plan has been going back and forth between all different political institutions, there now seems a probability that this plan might get implemented at some point in the future. The unwillingness of Republicans to act and to hold on too long to the belief that markets can sort themselves out caused huge damage. On top of that the economy and therefore the crisis has become “issue number 1” in the election campaign. Any plan of the opposition is obviously no good. As a consequence the only stores that see any turnover grow in the US are the so-called “Goodwill” stores.

The New Zealand situation resembles the US situation. It seems this crisis is too important to leave to politicians when there is an election around the corner. Voters looking for some leadership during the debate saw two politicians rudely interrupting each other, which resulted in unbearable noise.

Other policymakers want us to stay calm and dare not make any comparison with 1929. It would be good if politicians and policy makers would listen a bit more closely what economists have to say. We face a serious crisis. Paul Krugman, who won the Nobel Prize last Tuesday pointed out he never expected to see something that resembled the 1930’s in his lifetime.

Professor Krugman is not alone. Politicians looking for the usually rare “one handed” economists can these days have their pick. Not even in 1929 have so many economists agreed. People who claim this crisis differs from 1929 – when governments did not act fast enough – should realise this might be a consequence of actions of policy makers who were willing to believe that the current situation resembles 1929.

To date, New Zealand responses are too little too late. European policymakers seem aware that markets cannot always be trusted to generate the right outcome. If a bank cannot trust another bank to be around tomorrow, it will not lend the other bank money and vice versa. It does not matter how liquid the market is. Even if both banks are solid, the market fails. If banks do not lend to each other they will not lend to us and the real economy comes to a grinding halt.

Not only is this already affecting mortgages but fears are that it will start to affect credit card loans too. The main issue now is trust. Trust that you will get your money back.

Europe has taken the right steps and responded speedily. The US is lagging behind and pays a huge price. When the dust has settled they may no longer have a financial sector.

New Zealand policymakers should consider Europe’s approach. Offering deposit insurance is a first step. It means that we need to monitor financial institutions carefully, especially, because these institutions now have an incentive to start taking on too much risk.

But regulation is long overdue. Let’s face it, New Zealand looked like a financial Wild West without proper regulation of finance companies. But we need more. A large drop of more than 1 per cent in the interest rate sooner rather than later. While we are too late to show global commitment there is no need to wait until 23 October. A large interest rate drop now can reduce that impact on the real economy substantially and even create opportunities because of a lower Kiwi dollar. Inflation should not be a worry as most of the inflation is oil related and imported and thus beyond our control.

We should also go beyond deposit insurance and guarantee wholesale lending. Again sooner rather than later. Banks in New Zealand are not likely to get in trouble, which should make this a relatively cheap guarantee. But it will also prevent us from getting in trouble as international banks may now bypass our financial institutions. More importantly New Zealand politicians should show real leadership and work together during this election to fight the crisis. It would be good if they spoke with one voice, rather than - as they did during the debate last Tuesday.

Professor Ben Jacobsen is Professor of Finance based at Massey's Albany campus.


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