Wall Street Journal Article - Global Crisis Resists Central Bank Moves

December 18, 2008

Policy makers around the world marched ahead Wednesday with efforts to stimulate a withering global economy that so far has overwhelmed their attempts to contain the damage.

Central banks in Norway, the Czech Republic, Hong Kong, Saudi Arabia, Oman and Kuwait cut interest rates, a day after the Federal Reserve slashed its rates and promised more unconventional lending to battle the deepening U.S. downturn. Additional interest-rate reductions are becoming more likely in places such as Japan, the U.K. and the euro zone.

A number of central banks cut their policy rates Wednesday on the heels of Tuesday's action by the U.S. Federal Reserve. How some central-bank policy rates have changed since August 2007

The interest-rate moves come in addition to potentially a trillion dollars of fiscal stimulus that is being lined up around the globe for 2009.

As rescue efforts mount, economists are struggling to explain why nothing so far has worked to avert a deep recession.

J.P. Morgan economists estimate that the global economy will contract at a 3.7% annual rate this quarter and at a 2.3% pace in the first quarter of 2009 — possibly the worst six-month stretch for the global economy since World War II.

A range of answers to the economic quandary are emerging. Though the Fed has been cutting rates aggressively for more than a year, many other countries turned to stimulus only a few weeks ago. It will take time for those efforts to take root. Moreover, policy fumbles and half-measures have in some cases made matters worse. And the force of the credit crisis is proving far greater than many imagined.

While the U.S. is ahead of most other countries in its efforts to stimulate growth, many economists say its banks are still short of capital to cushion losses, making them reluctant to lend.

Between August 2007 — when the credit crisis started — and September 2008, the Fed reduced interest rates from 5.25% to 2%. Outside the U.S., however, interest rates inched up during that stretch, according to J.P Morgan.

Expectations that the central bank will cut interest rates rose after the government urged the Bank of Japan to do more to support the economy and the Federal Reserve reduced its benchmark to as low as zero.

That changed dramatically in October. Global rates outside the U.S. have been cut 1.3 percentage points since then, according to an average weighted by GDP. J.P. Morgan estimates that fiscal stimulus through tax cuts and government spending could amount to 1.5% of global gross domestic product in 2009, or about a trillion dollars, after being nonexistent outside the U.S. in 2008.

"Up until really early October there was no stimulus coming outside the U.S. at all," said Bruce Kasman, a J.P. Morgan economist.

The European Central Bank still has room to lower its official interest rate from the current 2.5% as inflation cools sharply, ECB governing council member Axel Weber said Wednesday.

Meanwhile, minutes from the Bank of England's Monetary Policy Committee meeting earlier this month suggest that the U.K.'s central bank is poised to cut rates further. The minutes showed that bank policy makers saw a "significant probability" of inflation undershooting its 2% target and considered aggressive rate cuts.

A slow policy response is only part of the problem. Economists also are increasingly taking aim at the choices policy makers have made in recent months.

"Virtually all of the policy initiatives implemented thus far to underpin financial-market functionality have tended to be partial, rather than comprehensive," John Lipsky, deputy managing director of the International Monetary Fund, said Wednesday in a speech in New York that was critical of other policy makers.

At the root of the downturn, he noted, is a powerful process known as deleveraging in which firms and households cut back on their dependence on debt.

Even though hundreds of billions of public dollars have already been spent globally to protect banks from losses on bad debt, Mr. Lipsky said policy makers around the world haven't done enough to recapitalize banks and root bad debt out of the financial system.

"Financial market deleveraging is still under way, underpinning our base-case expectation of a substantial and sustained slowdown in credit growth through the coming year," Mr. Lipsky said.

Simon Johnson, a former chief economist at the IMF who now is a professor at the Massachusetts Institute of Technology, estimates that, overall, financial institutions around the world will need to write down at least $1.7 trillion of bad debt tied to U.S. mortgages and corporate and consumer debt, but are less than two-thirds of the way through that process. They also haven't raised enough capital to buffer themselves from losses, he said.

John Taylor, a Stanford University economist and former Bush administration Treasury official, argues in a recent paper that U.S. policy makers shot themselves in the foot in late September by sowing confusion about how they would use public rescue money for banks. (Read the paper.)

His paper shows that a critical measure of risk aversion in the banking system — an interest rate called the London interbank offered rate, or Libor — shot up soon after Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified on their plan to Congress. Uncertainty about the U.S. plan, in other words, pushed up the cost of borrowing.

That might have been even more disruptive than the failure of Lehman Brothers Holdings Inc. a week beforehand, Mr. Taylor said.

"Government actions and interventions caused, prolonged and worsened the financial crisis," he argued in the paper.

The Treasury and the Fed declined to comment.

Despite the missteps, some signs are emerging that government actions are having a bigger impact. In the U.S., mortgage interest rates declined Wednesday in the wake of the Fed's rate cut Tuesday.

U.S. mortgage rates have fallen sharply since late November, when the Fed said it would begin purchasing debt issued or guaranteed by Fannie Mae, Freddie Mac and other government-backed mortgage finance businesses. That could help to ease the strain of a worsening housing downturn.

Moreover, Libor rates have fallen about three percentage points from their mid-October highs.