EYE ON
AMERICA Fed primed for
reform By Walter T Molano
There were two important lessons from the
collapse of the Japanese asset bubble during the
early 1990s. The first was that reductions in
interest rates are not expendable. Once the
discount rate falls to zero, there is nothing else
a central bank can effectively do - other than
flood the market with liquidity. It loses most of
its moral authority and sway over the financial
sector.
The second lesson was that the
financial sector should be forced
to
implement structural reforms before the central
bank looses control over monetary policy. Given
the role of the financial sector in safeguarding
the electorate's liquid savings, it possesses
enormous political clout.
Therefore, banks
are strident whenever they need assistance, even
if their misfortunes are the result of their own
mistakes - as is usually the case. This explains
some of the histrionics displayed by their agents
in the financial media.
During the early
1990s, the central Bank of Japan slashed interest
rates all the way down to zero, mainly because of
the clarion calls of the Japanese financial
sector. The Japanese monetary authorities hoped
that the banks would implement structural reforms
along the way - only to see them refuse and
prolong the crisis for more than a decade.
Unfortunately, the United States is moving in the
same direction.
The US financial sector is
in need of reform. The failure of regulatory
bodies to keep up with financial innovations,
mainly because of heavy lobbying from the
financial sector, allowed serious distortions to
develop. The problems were most prevalent in asset
management, derivative structures, and the rating
system.
The lack of transparency and
accountability in all three sectors allowed abuses
to take place, which in the end put the entire
financial sector at risk. Now that the damage is
done, and the liability is starting to shift to
the public sector and society at large, it is time
for the US government to act.
This seems
to be a situation that is recognized by the US
Federal Reserve. It is perhaps for this reason
that the Fed is keeping its powder dry. Besides
waiting for a better assessment of the problem,
the delay in implementing a thorough easing of
monetary policy may be an attempt to gain the
dominant hand in implementing reforms.
A
reduction in Fed Funds, without new financial
reforms, would only delay the adjustment and
compound the problems. This was the flaw of the
Alan Greenspan era at the Fed. Faced with the
Long-Term Capital Management meltdown in 1998, the
Fed led a rescue package, but it did nothing to
improve the transparency and accountability of the
derivative and asset-management industries - thus
reinforcing moral-hazard behavior and converting
an esoteric anomaly into a global financial
crisis.
The unilateral reduction in Fed
Funds will not attend to the confidence crisis
that is spreading throughout the globe. Whatever
the Fed decides to do, the credibility of the
credit-rating agencies has been permanently
damaged.
Credit committees and bank
regulators throughout the world will no longer
blindly trust the rating system. The same goes
with the collateralized-asset system.
The
unwillingness of international asset managers to
trust structure products implies that there will
be massive deleveraging. Without access to
limitless financing, the US consumer will have to
retrench, leading to a slowdown in global demand.
Therefore, the damage is done.
The best
thing for the Fed to do is to implement measures
that will mitigate the damage by restoring
confidence in the US financial system, but that
requires reforms. It needs to enact such measures
before there is a reduction in Fed Funds. Waiting
until after a reduction in rates would leave it in
a similar position as the Bank of Japan during the
late 1990s, thus condemning the global economy to
a long period of low economic activity and
asset-price deflation.
(Copyright 2007
Walter T Molano, The Emerging Market Adviser.)
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