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Live by the sword, die by the sword

Have policymakers sent the wrong signal to financial markets?

Market participants make many assumptions when times are good: for instance, liquidity is taken for granted. Another assumption is the primacy of unfettered markets. When times are good it is often vociferously stated that interference from the authorities will kill the goose that lays the golden egg. It is remarkable how quickly assumptions change when the bad times come, however. This must make life uncomfortable for policymakers – especially when warnings about excess have generally been ignored – who are suddenly told laissez faire is not appropriate or sensible. Central banks are told to cut prime and discount interest rates, while pumping the financial system full of cash is pronounced an imperative. It is remarkable because it is widely accepted that it was Federal Reserve chairman Alan Greenspan’s series of interest rate cuts that triggered the US housing boom.

In the US, the administration has finally succumbed to calls to put in place a safety net for the millions that listened to unscrupulous mortgage brokers and now face the possibility of losing their homes. Leaving to one side whether the expansion of the Federal Housing Administration programme will have a material impact – and there are plenty of experts that doubt it will – policymakers should keep uppermost in their minds the effects that short-term palliatives can have in the long term. Will lenders and borrowers be more aggressive in the next upturn in the residential real estate cycle? And how will investors in private label MBS react to the possibility that the best sub-prime loans are being cherry-picked by a government agency? In such circumstances – where the woes are mostly self-inflicted – it is questionable whether governments (or their agents) should bail out the misguided, greedy and hopeless.

A lack of money-market liquidity prompted the Fed and European Central Bank to flood the system but it is worth asking whether this is the right course of action – there should be consequences to playing risky games.

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