Monetary Response – Is the end to the crisis near?

One would like to think/hope that the financial institutions, marred with the deepest credit squeeze since the great depression, are looking for coordinated monetary responses from the world leaders and that would kick start the inter-bank lending and bring this whole crisis to an end. I am certainly one of those hopefuls. However, the more I look at their planned responses, the more I’m convinced that it’s far from over. The monetary action, in my opinion, is a going by the book response. These are extraordinary times and I believe just the monetary response won’t work, call it coordinated, unprecedented, or whatever.

This crisis has three different aspects in my view and every aspect needs to be addressed at the same time to see a definite result by next year. I’m very sure someone will learn that lesson before the world economy learns it the hard way. First aspect is certainly the credit squeeze that the entire world is witnessing. Second is the lack of trust between banks and main street that’s hurting the consumer lending in the US. And the third is the declining home prices in the US. The monetary response is an attempt to fix the first aspect only and the hope that it’ll trickle down into the economy soon enough, has little ground.

A quick analogy to the two missing aspects in the response can be cited here. Consider a laborer who makes his living by lifting loads (say 200lbs). Assume he is bleeding now and thus is growing weaker by the day. He is using one of his hands to control the bleeding hence he can’t bear the load properly with another. With both hands full, he doesn’t take medication since he doesn’t trust the medication will work faster to stop his bleeding and believes he is better off using one hand to keep a stop on the bleeding. Will providing the man with too much of medication (liquidity in our case) help?

The ideal response should be (in that order): Lighten the man’s load (to say 100 lb), put some sort of bandage on his wound to stop the bleeding and then administer the medication for healing. This will help the man heal and get stronger again. The fed has learned that the man (economy) is not willing to take the medication and hence it has decided to administer the medication into the man itself (taking ownership in the banks and deciding to lend directly to corporations). But is that the solution? The medication might take time to heal the wound and the man might get crushed lifting the load with one hand before the healing happens. I believe measures must be taken on the other two aspects as well and the time is now.

The second aspect is a larger issue that must be addressed soon. With the shrinking job market in the US and increasing unemployment, people aren’t spending as much. Additionally, banks aren’t willing to lend to common man since they don’t know how risky the person is with declining wealth through the US housing. We have already seen this mistrust hurting the auto dealership, retail, housing etc. and it is directly affecting the economy through declining consumption. The good news is that this direct impact to economy is true in times of improvement as well. A quick solution here lies in the fiscal policy through a long term tax break (as opposed to one time rebate checks) for common man that will improve consumption and will have positive impact on the US economy immediately. Improvements to the world economy will follow.

The third aspect is the declining home prices that are making the wealth disappear from the US. In reaction, it’s hurting the mortgage backs and due to exposure to these securities by foreign countries, world economy is feeling the heat as well. Believe it or not, it’s in the interest of the world at large to ensure the US home prices stabilize and that too, very soon. The inaction here might lead to similar symptoms in asset backed and even in treasury securities as wealth continues to get wiped off. As I have said earlier, either some principal write off or a permanent rate cut in the existing mortgages around 1-2% will not be a bad deal for the world after all.

These two responses will have an immediate income effect on the US population overall and rebuild the lost trust between lenders and common borrowers. The permanent increase in income would get the consumers out of their doors to start spending and banks will see the transactions going up. The increased transactions will make the banks look for more short-term cash, inter-bank deals, and lending. This is where the liquidity infusion (medication) into the system will really help.

To conclude, my belief is that this is an extraordinary situation that requires matching responses. The response should be not only top down (Monetary) but also bottom up (Fiscal) and side ways (Government direct support to home owners). Unless the policy makers realize this, we are all in for a continued long term mess, and as someone rightly said, a mess that might provide Mr. Bernanke another chance to study the great depression better.