US offers a lifeline to global financial markets

22 September 2008
The unprecedented bail out of the US banking system has prevented a depression at a massive cost to the nation’s taxpayers, and has also had a positive effect on GCC equity markets.

The Wall Street crash of 29 October 1929 was the start, but not the cause, of the Great Depression which at its worse made almost one-quarter of US workers jobless. The US economy did not fully recover until the US entered the war against Germany and Japan at the end of 1941. Unemployment was still an issue for at least a year after that.

It was believed for more than three decades that deficit financing ended the Great Depression, but this has been proven to be false. Milton Friedman and his wife Rose revolutionised the conventional wisdom about the Great Depression in their seminal book, the Monetary History of the US 1867-1960.

They argued the depression was caused by excessively tight monetary policy following the stock market crash, and that the recovery was mainly due to lax monetary policy, which eventually led to high inflation in the 1970s. Friedman’s arguments destroyed the Keynesian idea that public spending alone could be used to end the business cycle.

Almost seven decades later, the administration of President Bush seems to have learned the lessons well. They concluded that the wrong policy, or the right policy pursued in a half-hearted way, would be almost as bad as no policy at all. After working out the scale of contaminated debts on bank balance sheets, and adding a large margin just in case, US Treasury Secretary Hank Paulson and Federal Reserve chairman Benjamin Bernanke told the White House that they might need as much as $1 trillion to restore confidence by buying them.

Unlike his Republican predecessor Herbert Hoover, who thought a lot but did the wrong things in 1929-32, Bush characteristically allowed others to do the thinking for him.

On 19 September, Congress was told the outlines of the administration’s plan. Its details were still not clear as this article was being written, but it seems it may entail the largest injection of government finance into the economy in US history.

Doctrinaire Republicans, who oppose public spending and government intervention in principle, were horrified. But the pragmatic majority in both of America’s major parties could see that the plan, although it was a gamble, was better than doing nothing. Confidence in the banking system was so low that interbank lending had effectively stopped.

Banks in turn were reluctant to lend long-term. The gloom seeping out of Wall Street was quickly affecting household and corporate behaviour. It was only a matter of time before banks would be hit by unsustainable demands for cash withdrawals. A domino collapse of smaller US banks was almost inevitable. The spectre of a new Great Depression loomed.

The additional pressure on the US government was the recognition that a collapse of the US financial system would devastate world banking and be particularly damaging to the US’ closest allies. The demand for something to be done was also voiced by most Western finance ministers.

The result is that we may have seen the shortest financial crisis in history. By announcing a plan to inject a vast amount of liquidity into the banking system, the US administration has taken America from 1929 to 1945 in little more than a weekend. And Paulson has, perhaps, at last justified the hundreds of millions of dollars he was paid as the chairman of Goldman Sachs. If his plan works, it will be priceless.

American conservatives have stopped attacking the plan. But they warn that it will cost the US taxpayer. In the short-term, they are right. Talk of tax cuts now looks fanciful. But it is a price worth paying. The White House has done more to protect the world in September than it managed in the years since the 9/11 attacks.

The consequences for the Middle East are mixed. Oil prices won’t fall as sharply as appeared probable before 19 September. Global inflation is unlikely to ease by much. In the GCC, equity markets rebounded on the first day of trading after the US package was announced. There is talk that the UAE is preparing its own banking bail-out package to inject liquidity into the federal economy.

This is good news, but every silver lining goes with a cloud. Those hoping for a sudden drop in GCC housing prices will probably be disappointed. Another season for the five-year Gulf property spiral seems certain to start after the Eid al-Fitr holiday.

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