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Monday, Jan. 28, 2008

JAPANESE PERSPECTIVES

Nightmare becomes reality: Classic credit crunch leaves policymakers floundering


In this column last month, I talked about the nightmarish possibility of a global financial crash. Well, a month is a long time in economics, and the nightmare has well and truly become reality.

Share prices have fallen dramatically everywhere and show every sign that more of the same is just around the corner.

As for the subprime loan securitization issue that triggered the credit crisis, things just seem to go from scary to hair-raising. The ripple effects are even spreading to the "monoline" insurers who guarantee payments on those structured financial products.

"What next?" is the question on everyone's panic-stricken minds.

Meanwhile, governments and central banks are busy trying to stem the crisis. Nobody in their right mind would envy the task they are being forced to tackle.

All the same, this is also a golden opportunity for policymakers to prove their worth and display their command of economic fundamentals.

What we are dealing with here is a classic case of a credit crunch. While the world's economies may have globalized, the mechanics of financial meltdowns remain very much intact. Financial crises occur for a reason. In fact, they are the market's way of correcting excesses and unsustainable imbalances in the economy. This makes them something of a blessing in disguise if one manages to see through all the layers of evil-looking clothing.

The important thing is for the excesses to be corrected and the imbalances to be righted. This should remain the primary concern, however fearful the situation looks and however great the temptation to bail out everything and everybody becomes.

From this perspective, the British government's seeming determination to rescue the beleaguered Northern Rock bank come what may is worrying to say the least. Reports have it that the government is trying to make the bank more sellable to the private sector by letting it issue asset-backed securities.

This looks bizarre and reeks of desperation. Securitized products are what got Northern Rock into trouble in the first place. For it to resort to the same techniques in trying to get out of trouble is just short of farcical.

The U.S. Federal Reserve isn't exactly sailing through with flying colors either, in terms of policy integrity. Its all-out hurry to reduce interest rates may be exciting economic theater, but upon reflection it doesn't make that much economic sense. For what we are dealing with is a credit shortage, in which the creditworthiness of people and institutions is at stake. It is not a question of a liquidity shortage.

Imagine a person who has become persona non grata in all the bars around town because of unacceptable drinking habits or the inability to pay bills on time. That person is not going to benefit a bit from a reduction in the price of all the drinks on offer at the bars. As long as that person is denied entry to all the watering holes, the situation remains exactly the same for the poor fellow.

Not until someone comes along who is willing to both guarantee the drinker's debts and keep his more outrageous behavior in check will that person see his drinking prospects improve. The question then becomes one of whether it is necessary or desirable for such a rescue package to be extended.

The prospective guarantor will need to have all his wits about him to make the right decision on who to save and who to reject.

As will the Fed, should really big institutions turn out to be closet financial alcoholics. As indeed they might. This whole saga is far from over.

Noriko Hama is an economist and a professor at Doshisha University Graduate School of Business.


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