August 21, 2007 / 4:44 PM / 12 years ago

Wanted: Central bank with new answer to old problem

PARIS (Reuters) - Decades pass but the story remains the same — financial markets lurch from boom to bust, central banks rush in to avert disaster and their rescue operation sets the scene for yet another boom-bust sequel.

Federal Reserve Chairman Ben Bernanke on Capitol Hill, July 18, 2007. Decades pass but the story remains the same -- financial markets lurch from boom to bust, central banks rush in to avert disaster and their rescue operation sets the scene for yet another boom-bust sequel. REUTERS/Jason Reed

Governments, meanwhile, are asking how the present mess came to be despite all their endeavors to render the global financial system less accident-prone since the collapse of the LTCM hedge fund in 1998 or the world stock market crash of 1987.

Nearly 10 years after the demise of LTCM, central banks are racing to the rescue again, flooding money markets with emergency loans as calls mounts for them to go all the way down the road they took in ‘98 and ‘87, by cutting official interest rates.

The trouble that snowballed out of the U.S. mortgage market, compounded by a frenetic level of debt securitization over the past five years, has fuelled fears of damage to the banking system, sparking this year’s crisis.

Has the world learned anything since LTCM went belly-up in late 1998?

“Not really,” says Willem Buiter, economics professor at London School of Economics and a former member of the policy committee of the British central bank.

The risk now is that the Federal Reserve feels forced to cut its main interest rate to prevent financial turmoil hurting the economy or that the European Central Bank chooses to take its foot off the brake in the euro zone too fast.

Past experience suggests central banks overreacted, cutting rates more than was needed, says Dominic White, an economist at Dutch investment bank ABN Amro.

In the two weeks following the October 1987 market crash, the Fed cut its key interest rate by half a percentage point. The housing market took off and inflation kept creeping higher.

After LTCM’s collapse triggered fears of a systemic crisis in late 1998, the Fed cut its key Fed Funds rate by 75 basis points, or three-quarters of a point, which was more than sufficient, say White.

In both cases, rates were higher within 18 months than prior to the crises, and it looked as if it had all been overdone.

“In hindsight, it looks like the Fed over-reacted. Perhaps Mr (Fed chief Ben) Bernanke, a renowned U.S. economic historian, understands this better than some market commentators,” White said in a note he published on Tuesday.


Buiter from the London School of Economics says it is high time central banks thought of other, more imaginative ways to combat crises, arguing that massive liquidity injections in money markets are no longer enough.

Morgan Stanley’s Stephen Roach puts it even more bluntly.

He accuses central banks of failing to adapt to a situation that the U.S. Fed encouraged in the first place, one that led to the dot-com bubble that burst in 2000, and the credit bubble that has since formed in its wake.

When Alan Greenspan ran the Fed, says Roach, central bankers committed the “original sin of the bubble world”, ignoring a surge in liquidity which fed directly into asset markets.

“That set in motion a chain of events that has allowed one bubble to beget another, from equities to housing to credit,” Roach wrote in an article for Fortune magazine.

“As always, the cycle of risk and greed went to excess. Just as dot-com was the canary in the coalmine seven years ago, subprime was the warning shot this time. Denial in both cases has eerie similarities.”

Governments are wary of stepping on central bank toes in the main industrialized countries where the central banks are independent, but they may be tempted to think again.

“The art and science of central banking is in desperate need of a major overhaul — before it’s too late,” says Roach.

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