Monday, December 10, 2007

Economy Calls for a Big Rate Cut

I have just returned from a week talking with bankers in England and in Switzerland.

In Basel, I had an illuminating — but “off-the-record” — interview with the Bank of International Settlements (BIS), the important research and coordination working body for the world’s Central Bankers.

Although the initial positions presented by those whom I visited were to some degree less bearish than my own, I have to say that their confidential, final views began to approach my own, albeit they were seasoned with a hope that things would not unwind so drastically.

In summary, I picked up a certain sense of quiet pessimism, more in line with my own views.

Now back home in the United States, I saw The Wall Street Journal front page headline, “U.S. Mortgage Crisis Rivals S&L Meltdown.”

As The Wall Street Journal article points out, there have been five major debt crises since World War II.

They started in 1982 with the bank lending crisis, of which I warned in a speech in the House of Commons in 1980. It amounted to $55 billion, or 1.7 percent of gross domestic product (GDP).

This was followed by the Savings and Loan crisis. That amounted to $189 billion, or 3.2 percent of the then-GDP, but ominously lasted almost nine years, from 1986 to 1995.

The Japanese bank-lending crisis totaled $263 billion, or 7 percent of GDP, and lasted 11 years, from 1992 to 2003. It is most important to realize that Japan has still not yet recovered from the subsequent economic slump, triggered by a revaluation of its currency.

In 2000 to 2003, we experienced what became known as the dot-com bust. It was only $93 billion, a tiny 0.9 percent of GDP, but nevertheless a painful memory for many investors.

Today, the subprime mortgage crisis is estimated to be some $150 to $400 billion. That makes it 1 to 3 percent of GDP.

However, unlike the previous bank crises, our present subprime crisis is still running and looking worse by the day.

Indeed, only today, UBS – the largest money manager in the world – announced a second hit, this time for $10 billion.

This despite the fact that UBS has obtained a cash infusion. Pretty soon you’re talking real money, even for a major Swiss bank.

Today, Bank of America said it is closing its $12 billion money market fund because of losses in structured investment vehicles (SIVs)! Investors will receive less than par — from a money market!

When I warned our readers to be wary of money market funds that had invested in SIVs, some readers thought I was being unnecessarily alarmist. I was merely trying to warn our readers.

Looking at The Wall Street Journal article, I am struck not by the relatively small percentage of comparative GDP but by both the absolute size and complexity of the “toxic waste” within the subprime crisis and by the fact that it is both worldwide and held by unrelated investors, including Norwegian townships within the Arctic Circle!

This is causing a very dangerous credit crisis, affecting all but the most prime borrowers.

In addition, the size of our present problem, estimated at $150 to 400 billion, is still growing.

I believe that President Bush’s idea to freeze certain qualifying ARM re-sets is not an order but merely a suggestion! I fear that it will not work and that, by the time our subprime crisis is over, it will be recorded to have been well over the highest estimate of 3 percent of GDP.

In short I see daily, growing evidence that we are entering a recession. Those who disagree are growing increasingly desperate in their efforts to drown out that view and deny the opportunity to express it.

Not that I am the only economist to believe we are fast entering a recession. Far from it — at least for now!

But, by denying the free expression of opinion, our government risks making decision based upon false assumptions.

For instance, the Fed is due to make a crucial interest rate decision Tuesday.

The general expectation is for a quarter to a half-point cut. Indeed, the recent headline inflation number — without looking at the continued decline of manufacturing and construction jobs, inside the figures — may well give our Fed the excuse to lower rates by only a quarter of a point.

Here it is interesting to note that last week, both the British and the Canadians dropped their rates by a quarter-point. Sadly and despite calls from grass roots, the European Central Bank kept its Euro rate on hold.

I have often said that, depending upon the phase of the economic cycle and the shape and level of the yield curve, it can take between nine and 24 months for a Fed rate change to gain economic traction.

To divert our pending economic recession from morphing into a severe recession or worse will require a Fed interest rate cut to 1 percent or less. In saying this, I agree with bond fund manager Bill Gross of Pimco.

Even a half-point rate cut tomorrow will prove to be far too little and too late to meet the hopes of my friends the English and Swiss bankers, that a catastrophy will be avoided.

If the Fed does cut its key rates by half a point tomorrow, stock markets can be expected to rise. It will be a false dawn.

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