Recently I have been repeatedly asked – by commentators on this blog and others - the following questions: If you rightly believe that the current global financial crisis is one of insolvency and not just of illiquidity and is also due to fundamental incentive problems of financial agents in a world of asymmetric information why do you now recommend that central banks aggressively cut interest rates? Since you argue that monetary easing will not prevent the unavoidable hard landing why to support  a reduction in policy rates? Wouldn’t this monetary easing imply a bailout of reckless lenders, borrowers and investors, cause another asset bubbles and prevent the necessary – if painful – loss of asset values and restructuring of distressed claims? And wouldn’t this monetary easing risk causing high inflation at a time when such inflationary pressures are already rising? And since – as you correctly argued – the recently announced coordinated monetary policy injection by central banks has so far failed to affect liquidity spread in a significant way – why should easing policy rates make any difference?

The arguments against policy rate easing by central banks are thus threefold:

a) such monetary easing will not prevent a hard landing and will only postpone the necessary restructuring after a reckless credit-boom driven asset bubble;

b) it will cause moral hazard and possibly create future bubbles;

c) it may lead to higher inflation.

Let me argue why monetary policy easing – not just palliatives such as the liquidity injections announced by central banks this week but rather significant cuts in policy rates – are now necessary and warranted.

First of all, as argued here since August, the current global financial crisis is due to insolvency on top of illiquidity and due to fundamental problems in a world of financial globalization; and monetary policy easing will not – in my view – avoid a hard landing of the US economy and a sharp slowdown of global economic growth. Notice that the analysis that this is a financial crisis of insolvency - not just illiquidity is shared by very distinguished commentators such as Martin Wolf, Paul Krugman and George Magnus.

While aggressive monetary policy easing will not prevent a hard landing – as it did not prevent one in 2001 – the length and depth of an economic downturn is affected by monetary policy. And it is both the duty and responsibility of central banks to reduce partly avoidable severe economic downturn that lead to massive losses of jobs, welfare and incomes. The job of a central bank is not to bail out the financial system and/or investors but that of bailing out the real economy. Having millions of workers lose their jobs only to teach a lesson to reckless investors and lenders on Wall Street and the City does not make sense.

And while monetary easing will not prevent a US recession that is now necessary to clean up the credit mess, leverage and excesses that were built up in the last six years such monetary easing may reduce the length of such a recession and dampen its depth. Monetary policy may be impotent in affecting the likelihood of a economic downturn that is unavoidable given fundamental real and financial shocks in an economy; but it is not impotent in affecting how deep and long such a recession will be.  And inflicting severe misery and pain and collateral damage on innocent bystanders – i.e. the millions of individuals, workers and households – that were not necessary at fault is not sound economic policy.  Thus, a US recession and global slowdown may be unavoidable; but how ugly and painful and protracted it will be does depend on whether the Fed and other central banks start cutting interest rates to dampen its effects.

Second, would monetary policy easing represent a form of moral hazard and risk creating another asset bubble? Not necessarily. At this point the financial losses from the reckless credit bubble of the last few years are mostly unavoidable and will not be avoided by easier monetary policy. Starting in 2001 the Fed cut rates from 6.5% all the way to 1% by 2003; in spite of that the bust of the tech bubble continued: the Nasdaq fell all the way from a level of 5000 to about 1200; other stock indexes in the US and abroad sharply fell; thousands of internet companies that were mostly “vaporware” – i.e. with little revenues, let alone earnings – went belly up and bankrupt.  Thus that aggressive monetary easing did not succeed in bailing out investors.

Similarly today home prices that rose in a bubble like fashion by almost 100% in real terms between 1997 and 2006 will fall by at least 20% - if not more – regardless of what the Fed does; given the biggest glut in new and existing homes in US history and the biggest housing recession ever no amount of Fed easing will prevent this collapse in home prices. And the broader financial losses – that will be close to 1,000 billion dollars once you add sub-prime, near prime, prime, auto loans, credit cards, student loans, commercial real estate, leveraged loans and lending to the distressed parts of the corporate sector – will be massive regardless of what the Fed does.  And once the unavoidable hard landing becomes clear to market participants the current delusional hope of the stock market investors that the Fed can prevent such hard landing will fizzle out and stock price will sharply fall as well. In a recession there is no room to hide: in a typical US recession – with or without Fed easing – the S&P 500 falls by an average of 28% in nominal terms and almost as much in real terms.

When bubbles go bust the Fed can only minimize the collateral damage to the economy and reduce modestly the severity of the losses; it cannot prevent massive losses and sharp falls in asset prices from occurring as the experience with the S&L boom and bust in the late 1980s and the tech boom and bust in the late 1990s suggests.

So to those who are worried about moral hazard: don’t worry as reckless lenders, borrowers and investors will be severely punished as they are already. Of course if instead of monetary easing the governments were to provide direct subsidies to lenders or borrowers once could formally talk of a bailout; but nothing like that is in the cards. Even the modest Treasury plan to freeze reset rates for some mortgage is neither a bailout of lenders/investors or of borrowers. It does not bail out lenders/investors because, if anything, they will have to accept a lower stream of payments than the original mortgage contract; and it is not a bailout of borrowers as those who are insolvent will default anyone; the plan only helps those who are potentially illiquid but solvent to avoid a default that will be hurting both the borrower and the lender/investor.

Of course the overall losses and fall in asset prices may be smaller – with aggressive monetary easing – than it would be without it; but causing a much more severe and protracted recession that hurts most workers just to maximize the losses of reckless investors/lender is not sensible public policy.

How about the argument that easing a lot now will cause another asset bubble and a bigger mess down the line? After all Greenspan warned in 1996 about irrational exuberance and did almost nothing about it thus feeding the tech bubble of the late 1990s. And when that bubble went bust the Fed cut the Fed Funds rate too much and for too long thus creating the housing bubble. So wouldn’t a strong Fed easing cause another asset bubble and a bigger crisis ahead as the Fed looks like a serial bubble blower? One could cynically notice that the Fed may be running out of asset bubbles to create as even the private equity bubble is now fizzling out. But more seriously: the asset bubbles of the last decades – the real estate bubble of the 1980s, the tech bubble of the 1990s, the housing bubble of the 2000s – were due more to poor supervision and regulation of the financial system than to monetary policy ease.

Those of us who believe that central banks should have a symmetric approach to asset bubbles (see my paper on monetary policy and asset bubbles) – i.e. try to prick/contain them when they are on the way up so as to be able to ease policy and minimize the real collateral damage if/when they burst – rather than the Greenspan/Kohn/Bernanke doctrine of asymmetric response – do nothing on the way up when the bubble is growing while aggressively ease when the bubble burst – do also agree that monetary policy that tries to control asset bubbles on the way up is not necessarily and only based on the use of interest rate policy: poor regulation and supervision of the S&Ls caused that real estate bubble and banking crisis.

Similalry, the tech bubble would have not been stopped with a 50 or even 100 or 150 bps higher Fed Funds rate as manic investors were expecting 100% returns per year at the peak of that tech mania. Rather much larger margin requirement on leveraged investments in the stock markets would have been the more appropriate response. Similarly the latest housing bubble would have been restrained in modest measure if the Fed has reduced the Fed Funds rate less and started raising it earlier and faster. What created this mess was not as much monetary policy easing but rather reckless behavior of regulators and supervisors – including Greenspan and the Fed – who were asleep at the wheel while this reckless lending was occurring and, at times, were active cheerleaders – namely Greenspan – of all the financial innovations that led to such reckless mortgage lending and the increase in the leverage of the financial system.

Thus, the way to deal with the risk of new asset bubble is not to renounce to monetary policy easing that is necessary to reduce the real economy collateral damage of a bursting bubble; it is rather using the appropriate supervision and regulation of the financial system to ensure that a new bubble does not emerge from that monetary policy easing. It is still appropriate and legitimate use of monetary policy easing interest rates when an asset bubble bursts when both monetary and regulatory policies have been used to control a bubble when such a bubble is emerging; so a symmetric approach of monetary/regulatory policy to bubbles – rather than the asymmetric approach advocated by Bernanke/Greenspan/Kohn – is the appropriate way to minimize the risk of moral hazard and to avoid turning the Fed into a serial bubble blower.

Third issue: would monetary policy easing cause a much higher inflation rate and undermine the anti-inflation policy credibility of the central banks? After all inflation rates are now rising around the world thanks to high and rising oil, energy, food and oher commodity prices. My answer to the question above is no as a US hard landing followed by a global slowdown will seriously reduce those inflationary force and would – like in 2001-2003 – rather induce serious deflationary risks. Inflationary pressures may be elevated now but they will fizzle away in short order once the US hard landing is in full swing. Thus, the central banks current concerns with a rise in inflation are misplaced as a US recession will lead to global disinflation (and concerns about deflation as in 2002-2003). There are at least four reasons why these global inflationary forces will abate once this US hard landing occurs:

a) a fall in US aggregate demand relative to supply;

b) a slack in labor market conditions and slowdown in wage growth as the unemployment rates sharply increases;

c) a fall in global aggregate demand as the glut of output from overinvestment in China and some other emerging market economie will face a fall in global demand as the world re-couples with the US hard landing;

d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges.  

We are thus set for the repeat of the 2000-2003 cycle when the Fed and other central banks underestimated the downside risks to growth and overestimated the upward risks to inflation and ended up having to aggressively cut rates to deal with the fall in economic activity and the deflation risks that such a US and global recession triggered.

To conclude, I thus repeat what I wrote before the last FOMC meeting and before the coordinated monetary policy injections were announced this week; i.e. I argued against ineffective solutions such as monetary injections at unchanged policy rates and argued in favor of significantly reducing such policy rates:

So the time for band aid measures and clever but ineffective palliatives is over: only a monetary policy ease could make some difference in reducing the level of interbank rates (if not the interbank spreads) and avoid the sharp tightening in monetary conditions and rise in real short term interest rates that the spike in interbank spreads has created.

This author has argued for a while that a Fed easing will not prevent a hard landing as the more fundamental credit problems of the economy will not be resolved by monetary policy alone. That does not mean that policy rates should not be reduced in the US and elsewhere: a US recession will, at this point, occur regardless of how fast the Fed eases but the depth and persistence of such a recession will depend on how aggressive the Fed is. I.e. the Fed will not at this point be able to prevent a recession – for the same reasons why it did not prevent one (in spite of very aggressive easing) in 2001 – but it would be able to put a floor on the depth and length of such a recession.

The same holds for all the other major central banks: ECB, BoE, BoC, BoJ. There is now a serious risk of a global economic downturn in 2008 as the US is inevitably headed towards a recession and this recession is leading to economic recoupling across the globe. Given the lags in the effect of monetary policy – 6 to 9 months – the time to cut rates is now. As central banks have remained on hold – with the exception of the Fed and the BoC today – real short rates faced by financial institutions and all sort of other borrowers (as many private financial contracts are linked to Libor)  have gone up by 75 to 125bps in the last few weeks; this is a severe tightening of monetary and credit conditions. Thus, holding nominal policy rates steady means having effectively increased such nominal and real borrowing rates for banks,  financial institutions, corporations and even households (as most revolving consumer credit and ARM style of mortgage products are linked to short rates). 

So while we should not delude ourselves that cutting policy rates will resolve deep seated credit and insolvency problems among many distressed borrowers – and  resolve fundamental problems in a world of financial innovation, globalization and securitization that require fundamental regulatory reforms - that will take years to resolve, the alternative of not cutting policy rate aggressively is the risk of a global economic recession… 

And it does not make sense to avoid bailing out the real economy – and preventing a massive global loss of incomes and jobs – just in order to punish reckless lenders and investors in the financial market and thus avoid moral hazard. Moral hazard in financial markets is contained via sensible credit policy and appropriate regulation and supervision of financial markets. In times of economic danger bailing out the real economy with monetary easing may have the by-product of partially reducing the financial losses of reckless lenders and investors (an indirect bailout). But the first order costs of a global recession is much larger than the second order costs of partial moral hazard; such moral hazard will be kept in check by hundreds of billions of dollars of losses that will occur regardless of monetary policy easing and via sounder regulation and supervision of financial markets in the future up-cycle of credit. 

To conclude, as it is obvious to any sane person when your home is on fire it is not   a good time to sit in front of the burning building to discuss the merits of the moral hazard of fire insurance on your incentive to recklessly smoking in bed or debate the additional damage to your home coming from excessive use of fire hoses (the risk of higher inflation down the line). When your home is on fire and there is serious risk of fire contagion to all of your town and beyond you want the entire fire brigade to provide enough liquidity to avoid entire edifice and town burning to the ground.  And using hand-held and hand-carried buckets of water while pondering the intellectual merits of moral hazard of fire insurance in order deal with a major five-alarm fire - rather than using immediately your global fire brigade - is delusional.  So it is time for the international central banks’ liquidity fire brigades to turn on the hoses and dealing with this most dangerous global fire.

Unfortunately, this past week the central banks of the world – instead of using their most powerful and effective liquidity hoses – i.e. a reduction in policy rates – have stared at this most dangerous and spreading fire of a global liquidity seizure and decided to continue to use hand-carried and hand-held buckets of water that have proven ineffective before and have been ineffective again as liquidity spread have remained stubbornly high even after these new monetary injections were announced. They will realize in due time that much more effective and radical action – in the form of aggressive reduction in monetary policy rates – may be necessary and warranted. But it looks like they are already behind the curve – most of all the ECB – and what they will do ahead will be too little too late to address a fire that is now spreading without control from country to country.

There are now serious risks of a US hard landing and a severe global economic slowdown together with a generalized seizure of liquidity and credit in US and global financial markets. This is the most severe financial crisis that the global economy has experienced in the last few decades. But so far central banks have been deluding themselves that this is a temporary run-of-the-mill liquidity shock. It is time to recognize the severity of this crisis and take policy actions – that while unable to prevent now unavoidable and necessary massive financial losses and unable to prevent a US recession -  that will minimize the extent of the collateral damage to the global economy of the reckless US economic policies of the last six years.

For more of my views see two interviews that I gave on CNBC Asia last Monday December 10th before the FOMC meeting and the announcement of coordinated monetary injections. The first is Recession Inevitable; the second is Credit Crunch Unlikely to Ease.