KEY POINTS:
It is now abundantly clear why the Reserve Bank Governor took the surprising step of lowering the official cash rate by 50 basis points to 7.5 per cent last week. Alan Bollard had just returned from the annual meeting of the world's central bankers at Jackson Hole, Wyoming, where a bleak immediate future for the international financial system must have been painted. With the implications for this country's growth prospects uppermost in his mind, Dr Bollard needed to make a statement that left local banks with no option but to cut interest rates. He succeeded, but subsequent events have emphasised the degree of damage limitation involved.
The collapse of one investment bank, Lehman Brothers, the quickfire purchase of another, Merrill Lynch, and, most importantly, the weakness of insurance giant AIG have confirmed the depth of the American sub-prime crisis. Hopes that the worst was over have proved wildly optimistic. Events of the past few days are part of a continuum. The worst will not be over until the United States housing market bottoms out and the financial system is recapitalised. That could be a considerable time away. In the meantime, the global banking system will remain on tenterhooks, and bank borrowing costs will rise.
It is important, however, to keep events in context. References to a repeat of the Great Depression are relevant only in so far as they relate to Wall St banks. As yet, there has been none of the prolonged panic that led to the calamitous 1929 crash. This is also, as Dr Bollard stressed to a parliamentary select committee last week, a financial crisis, the worst since the 1930s, not the worst economic collapse since that time. New Zealanders are caught up mainly because of their heavy reliance on overseas borrowing. This becomes particularly problematic when in times of stress, lenders retreat to the safety of their own jurisdictions.
Crucially, US financial regulators have responded strongly and realistically to the threat of a credit market collapse. When stability is being questioned, decisive action must be taken to prevent panic. The Federal Reserve is providing liquidity support where it is needed to keep wheels turning. Its transfusion now includes a US$85 billion ($128.8 billion) emergency loan to shore up AIG, as well as the rescue of mortgage guarantors Freddie Mac and Fannie Mae. These were virtually compulsory exercises because all are integral to the financial system. AIG's problems stemmed from its insurance of mortgage-backed securities and other risky debt against default. If it could not repay soured debt, other financial institutions faced the prospect of collapse. The same significance could not be attributed to Lehman Brothers, which, fatally, underwrote more mortgage-backed securities than any other firm.
The Federal Reserve has been criticised for resisting pressure to cut interest rates. But the rate already stands at 2 per cent. There is little room to move and powder is being kept dry in case the turmoil intensifies. The Federal Reserve's New Zealand counterpart has, of course, no such constraint. Already, it is widely predicted that Dr Bollard's next move to combat the deteriorating international outlook and tightening credit squeeze will be a further 50-point reduction in the official cash rate.
Tax cuts will provide a further boost in the last quarter of 2008, and easing oil and food prices will provide household relief. Asia's continued economic expansion and relative strength will also offer some degree of solace.
It is clear, however, that growth expectations must be trimmed. Data will soon confirm this country is in a recession. The new reality is that recovery will be harder to spark.
