Sudip Bandyopadhyay’s Blog

The small but smart mouse usually outwits the large but dim cat in the endless game of chase between Tom and Jerry.  Occasionally, though, Tom’s energy and determination allow him to win, but the victories in the cartoons are usually only fleeting.  Tom rarely makes a long-term plan, and his reactive strategy allows Jerry to stay one step ahead.  The US government’s rescue of Citigroup is the latest bold intervention in the financial markets.  Wounded and bruised by the relentless slide in the value of the billions of dollars of debt on its balance sheet, the question is whether helping Citi is enough to stop the broader slide in asset values.  Is it another example of a Tom-like move that will have at best, a short-lived effect? Or is it a smarter, Jerry-like plan that could boost the confidence that has sapped away?

The answer matters for investors in equity and debt markets; the continual decline in debt values makes it madness for banks to lend and for investor to buy debt.  The US Treasury’s U-turn two weeks ago on plans to buy distressed assets made the credit markets resemble some of the violent scenes in Tom and Jerry cartoons.  They were sliced into pieces, forced to swallow dynamite and plugged into an electric socket: values plunged.  The improved chance of solvency for Citi does not suddenly make credit available to business and consumers or reduce the spiral of redemptions and forced selling.  For that investors need to be able to judge where the economic weakness will end.  The spotlight now is on Barack Obama and the president elect’s economic team.  The hope is that a holistic, long-term strategy – and not a Tom-like piecemeal approach – is devised.  The chase is not yet over: in spite of a rise in stock markets yesterday, the value of mortgage and credit-card-debt backed securities barely budged.

The world economy is suffering from a Keynesian shortage of demand. Worse, it is trapped in a dangerous downward spiral of falling asset prices, rising bankruptcies, foreclosures and unemployment feeding into more of the same, along with falling commodity and now goods prices. Since no country is exempt, international co-ordination is needed and made easier because of the obvious common interest. The rapidity of the current contraction also means that fiscal solutions, though helpful, are not timely enough and create obvious free rider problems.  It is therefore time for unorthodox policy,

A good example of this kind of unorthodox action is the Hong Kong Monetary Authority’s (HKMA) successful defence of the currency peg in the 1997-98 Asian crisis.  The HKMA intervened in the currency market, but more important were its purchases of Hong Kong equities, which speculators had sold short. These later made a net profit for the HKMA of US$14.1bn. The fact that many asset prices are far below fundamentals creates a parallel opportunity in the current global crisis.  Which assets should be included requires careful consideration. Buying commercial paper relieves short-term cash and credit problems for companies and has precedents in the UK and in the US. Buying bank shares on the open market is more controversial. One can ask why central banks should benefit existing shareholders rather than inject cash directly, as ministries of finance have done, in the recent past.

To avoid charges of favouritism, central banks may choose to buy index funds or individual securities in proportion to market capitalisation on transparent and organised security exchanges. This is also conservative since less cash will tend to go to securities that have fallen the most, and whose prospects look most risky to the market.  International co-ordination will avoid the policy being seen as a sign of weakness or panic at the individual country level, with costs to currencies and government bond markets. The incentive structure for central banks to join such concerted action is less likely to create free rider problems than is the case for fiscal policy. Any central bank considering such action has an incentive not to delay since the potential profitability is likely to be lower for late participants, given that asset prices will generally be bid up in the process.

Central bank discussions of such coordinated action could probably not remain entirely secret. Rumours could help stabilise markets, however. Some investors are beginning to fear that a growing government debt mountain induced by a slump will create incentives for future inflation. The reversible, self-financing and immediately applicable nature of the above plan should reduce these fears.