Capco Institute Blog

Over a year ago, Feb 2009, I suggested in a bulletin entitled “ECB’s recent decision is a dream come true for applied economists,” that the decision by the ECB to not cut interest rates allowed economists to test whether the untested actions of the Federal Reserve and the Bank of England would actually help stave off an economic collapse within the major Western Economies or whether it could be possible to prevent economic collapse by less aggressive fiscal and monetary actions.

I stated that “Earlier this week, when discussions were underway about whether the Bank of England should cut interest rates even further, many were of the opinion, except of course those economists who work for banks and the future of their employers and their jobs depends on low interest rates, that a further cut would not have the desired effect and that in fact it might result in people reducing their savings, an important source of funding for many building societies, putting further pressure on some lenders to reduce the quantity of mortgages they offer. It is early days to see whether their concerns were valid, but there is no doubt that the cut does reduce the number of tools available to the Bank to navigate through the current, and upcoming, crisis. Of course, the Bank of England could follow its U.S. peer and cut rates to zero and then start printing money to buy government debt, thereby increasing the money supply. But, the fact is that the history of such activities is not that promising. There are few, if any, examples of such major gushes of liquidity into the system that have not had even more severe implications for the economy. But, then again, if every country does the same thing it might just be different. The problem, of course, is that not all countries can follow in the footsteps of the U.S., whose currency is still the world’s major reserve currency. The implications of printing more money for the U.K. might be very different to that of the U.S., the value of whose currency will follow a very different downward slope in response to an increase in money supply. The other fact is that the ECB would find it hard, if not impossible, to replicate the actions of both, since the decision about which country’s debt to buy is a difficult one.”

Well, after a while the ECB did also follow in the footsteps of the U.S. Fed and the Bank of England, but not as nearly as severely as they had, and the euro and Sterling both collapsed against the dollar as we had predicted. The Greek crisis did not help, but still the ECB was not remotely as aggressive as its two Western peers.

A few months after the stimulus package was issued the world started to believe that we have turned a corner, even though a similar upturn was experienced during the Great Depression, and many were talking about when and how to remove the stimuli. Well, the news that the Economic Cycle Research Institute (ECRI) leading indicator dropped faster than at any time since the Second World War to -6.9 means that the Fed might be forced to not only not cut the amount of liquidity in the system but to in fact increase it dramatically.

Europe might also not have got away Scott free, no matter what the BIS is saying. If European banks are, as we had predicted a couple of years ago, hiding the true extent of their toxic assets (helped by cheap capital), then the next wave of defaults will force them to realize another huge batch of losses. This would mean that the ECB will also be forced to pump more liquidity into the system to prevent these major banks from failing.

As for the actions of the FED, well if the recent banking regulation pushed by President Obama is passed then there should be no need for further stimulus to help protect banks from failing, since there is now a very efficient system in place to protect the wider economy from the failure of a large bank or a number of large banks. But, somehow, I doubt that even if that legislation passes as is that the FED will not pump more liquidity into the system. The extent of potential collapse is so large that this time the wider economy might bring the banks down, rather than the other way round.

As someone who spent many months in hospital watching patients who were on life support machines I can tell you that keeping a patient alive requires a very careful analysis of the amount of medication and blood that is within their body. Pumping lots of blood into a patient is not always good, since it can place too much pressure on the heart and can cause heart failure. If the U.S. economy is on a life support machine, then the FED might in its haste to save the patient just push too much blood into the system and make the patient undergo a cardiac arrest.

The mere fact is that the actions of the FED are based on hypotheses that are trying to implement decisions that are exact opposites of what was done in the 1930s. They are not ideas that have been tested before. If the FED is not careful we might this time give the patient too much blood simply because it received too little 80 years ago, and if they get it wrong then god help all of us.