To check the global financial crisis, central banks worldover have introduced a half-point interest-rate cut.
But far more is needed urgently. These rate cuts may have a significant positive effect, if done promptly. Otherwise, their effect could be minimal. The world’s major central banks have been slow to respond to the deepening crisis. This is mainly on account of the dominance of conventional economics, guiding the thinking of the global central banking community. As a result, central banks failed to see the oncoming financial catastrophe, and even after it arrived they continued to fight the last war against inflation.
The European Central Bank and the Bank of England have performed miserably. Hardly surprising since most European central bankers are considerably conventional in their thinking and obsessed with inflation. It also explains why Europe has had such high unemployment rates for so long.
In this respect, the United States has done a much better job, though it, too, is repeatedly playing catch-up with a crisis that has persistently remained one step ahead of policy. This action reflects America’s own obsession with price stability that encourages interest-rate increases to head off inflation, but fights shy of rate reductions to ward off unemployment.
America’s interest rate stayed unchanged despite the collapse of mortgage giants Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, AIG’s insolvency, and the emergence of global financial tsunami. And despite rapid deterioration in America’s real economy, indicated by accelerating job losses and rising unemployment.
The rate cut now undertaken by major central banks so-to-say is a policy catch-up, but further cuts are needed. Whereas the oft-repeated whistle of inflation seems finally to have been put back into the pocket, another myth must still be pulverized – that the US’s and other central banks should not cut cutting rates.
It is believed that monetary policy is useless in recession because the effect of lowering interest rates fails to produce desired upswing in money markets. Since confidence is severely battered, borrowers remain unwilling to borrow and lenders unwilling to lend. The destruction of wealth also destroys collateral, which means that even those who wish to borrow cannot.
By not acting in a timely manner, central banks have allowed a dangerous erosion of confidence and wealth. Fortunately, there is still time for decisive rate cuts now to have a robust impact.
But the opportunity is closing fast. If central banks save their rate cuts now, they may find their "saving" redundant. The time to do so is now.