Business Line The Hindu Group

US economy: Between zero growth and recession?

S. Balakrishnan

It is the most often heard question these days. When will the crisis afflicting First World financial institutions end?

There seems no early or easy way out, this despite the coordinated and independent gigantic rescue efforts of the U S Federal Reserve, the European Central Bank and Bank of Japan.

They have gone the full distance and more in support, waiving collateral standards and financing illiquid assets in banks’ balance sheets.

The amounts involved are not small, running into hundreds of billions of dollars, euros and pound sterling. And when it came to it, the Fed was there to bail out Bear Stearns, one of the world’s large investment banks and absorb its possible portfolio losses even after the J P Morgan takeover.

Myth and reality

As stated in these columns on several occasions, it is a myth to think that central banks are ivory tower institutions concerned only with finessing monetary policy and interest rates.

Theory and textbooks divide governments’ and central banks’ responsibilities into neat compartments. Reality is that the latter must get their hands dirty.

No stronger evidence than the active involvement of the inflation-targeting ECB and Bank of England in the present crisis is necessary.

The ECB in particular - an arch monetarist institution if ever there was one - was forced to eat crow.

Financial markets are still far from normalisation. Credit spreads in the inter-bank market are well above historical levels - in the region of 100 bps vs 25bps and less in the good old days. The story repeats in housing mortgage rates. They have been hardly impacted by the rapid succession of Fed rate cuts.

Meanwhile, house prices continue their downward journey, with the only buyers in sight being the bottom fishers. There are reports of sovereign wealth funds investing in distressed mortgages and foreclosed properties.

Revival?

But can the market revive with just speculators in the fray? The canon fodder for sub-prime, Alt A, ARM and other various fancy-sounding mortgages were mostly genuine home buyers. Now they are gone, with no hope of qualifying for loans in the new regimented credit regime. Earlier, mortgage originators could securitise their portfolios and transfer risk, but that prospect too is remote with the collapse of the CDO market.

The US may yet escape the doomsday scenario painted by Mr Nouriel Roubini, the economist who first predicted the sub-prime crash and thinks major institutional, market and asset price upheavals are in store. But that does not mean an early recovery. There is more of bad than good news ahead and it is quite on the cards that the economy will simply flirt between zero growth and recession.

About the only comfort might be the softer price implications for energy and commodities from a weak economy.