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LETTER FROM EUROPE

Turmoil in the stock markets

In any case, it seems that the Fed’s current measures will not be enough to stop the downturn. According to Professor Stiglitz, measures like higher unemployment benefits and tax rebates aimed at lower and median income households, which have been suffering from cash shortage for some time, are likely to have instant effect on the economy because cash received through these means would be spent immediately.

Chakiader Mahboob ul Aiam writes from Madrid
FEARING that the United States was already in recession, stock markets across the world went into a tailspin on January 21. Next day, in a surprise move, the US Federal Reserve lowered its target for the federal funds rate, from 4.25% to 3.50%. The Fed did not beat about the bush to justify its decision. It was completely upfront about its intentions. In a statement, it said that it took "this action in view of a weakening of the economic outlook and increasing downside risks to growth....broader financial market conditions have continued to deteriorate further for some businesses and households. Moreover, incoming information indicates a deepening housing contraction as well as some softening in labour markets." Just so that there are no doubts about a possible US recession, the Fed added, "appreciable downside risks to growth remain."
The most important power of a
central bank is to control money supply. Therefore, the main objective of the Fed in lowering the federal funds rate is to expand money supply so that banks can lend it out to private consumers and corporate investors and thereby stimulate economic activity.
Although most experts now blame Greenspan's low interest rate policy for a possible recession, Bernanke is partially responsible for it. Bernanke was a Fed governor in 2001. In the aftermath of the 2001 recession, most economists were afraid of a possible deflationary situation, in which "falling prices force economic activity to slow down, then further drops in prices lead to even less economic activity, and so forth."
As a consequence, Bernanke supported Greenspan in pursuing a low interest policy, which unfortunately led to the housing bubble and eventually to the subprime mortgage meltdown. Banks indulged in reckless lending
practices, like issuing mortgages without any collateral, often without verifying the income of the borrowers because they felt that house prices would keep rising indefinitely. No doubt, Greenspan was negligent in not exercising the Fed's regulatory powers to keep the situation under control.
Then the financial institutions did something even more reckless. "Mortgages were bundled with others and sold to investment banks, which, in turn, sliced and diced the claims to produce artificial assets that Moody's and Standard and Poor's were willing to classify as AAA." In other words, they were, in theory, as good as US Treasury securities.
This was fraud on a massive scale, perpetrated right under the noses of the Fed, the US Treasury and the SEC, and no one did anything to stop it. Last summer, a large number of these securities were downgraded. People stopped buying them. Then, like
an infectious disease, the turmoil in the sub-prime market spread to other parts of the securities market like short-term commercial papers, creating a huge liquidity crisis.
Central Banks on both sides of the Atlantic pumped billions of dollars into the system to create liquidity. But economic activity involving both consumer spending and corporate investment continued to decelerate because people's confidence in the system had been badly shaken. Many banks reported huge sub-prime losses.
The problem is that even now no one knows exactly the extent of the banks' real exposure to these willing assets. Inevitably, these losses will rise sharply as mortgage defaults rise. No wonder the banks are now more worried about their own survival than about the problem of stimulating the economy.
In any case, it seems that the Fed's current measures will not be
enough to stop the downturn. According to Professor Stiglitz, measures like higher unemployment benefits and tax rebates aimed at lower and median income households, which have been suffering from cash shortage for some time, are likely to have instant effect on the economy because cash received through these means would be spent immediately.
At the same time, in order to restore confidence in the financial system, the government should take appropriate measures obliging the financial institutions to make full disclosures about their exposure to the subprime assets.
While, according to the Bureau of Economic Analysis, the personal savings rate in the US is almost zero, household debt stands at 133% of personal disposable income. As columnist Bowring pointed out, "personal savings rate has been declining steadily since a double digit level in the early eighties, a decline that has been in part driven by rising asset prices which masked the need for saving out of income rather than relying on credit driven boosts to apparent wealth.” In other words, American families have been borrowing against their homes (home equity) to take care of their day to day expenses.
Perhaps it was a good policy
when home prices were rising. But now that the bubble has burst and property prices are plunging, banks are setting aside billions of dollars to cover defaults on these home equity loans. Unfortunately, in this globalised world, the effects of the collapse of the US housing market and the sub-prime meltdown will spread to other parts of the world.
There is no doubt that economic growth in most parts of the world is gradually slowing down and the United States is the focal point of the slowdown, where unemployment has risen to 5%. Although the fundamentals of the EU economy look good, its export market will inevitably suffer because of a rising Euro and the ECB's reluctance to lower interest rates.
Some economists argue that US slowdown will not affect the emerging countries because their domestic markets have developed to such an extent that exports matter far less than they did in the past. This is probably wishful thinking because, in this globalised world with ever-rising food and oil prices, if there is a significant fail in consumer spending in the largest economy of the world it will affect the economic growth of the developing countries sooner or later.
Cra Wader Mahboob-u! Alam a a columns! for The DaiyStar