Can bankers save the world? Investors say no

By Jim Jubak

The simultaneous global meltdown in stock and bond markets from Bombay to New York is a vote of no confidence in the world's central bankers. Central banks everywhere are facing huge challenges. By selling shares and bonds for most of May, investors and traders said loudly and clearly that they don't think bankers are up to the job.

I don't think the current correction turns into a meltdown unless one of these banks stumbles really badly. But I don't think the nervousness goes away until these banks, especially the big three -- the Federal Reserve, the Bank of Japan and the European Union -- prove that they aren't about to kill economic growth.

The details vary from country to country, but the problem is the same: Over the last decade or more, the world's central banks have made a bad bargain with governments that collect taxes and then spend the tax receipts plus borrowed funds. Rather than letting the irresponsible fiscal policies of governments from Beijing to Washington damage national economies, the central banks decided to use their control of the money supply to postpone the consequences of fiscal folly.

Now the bill is coming due, and, although the central banks still think they can put off paying the bill for past behavior, investors are less and less certain. Some days, in fact, they get positively panicky.

The Fed knew the bill would come due

Let's start with a look at the U.S. Federal Reserve because it's most familiar and closest to home. The Fed decided to fight the effects of the stock market bubble burst of 2000 by taking interest rates down to 1%. That created a real estate boom, which drove up housing prices, making us feel better in the United States about all the money we'd lost in the stock market crash. Interest rates of 1% also created a mortgage refinancing and home-equity lending boom as homeowners rushed to take some of that new equity out of their houses and spend it on a second home, a new car, a vacation, whatever. The resulting surge in consumer buying prevented the stock market crash from sending the general economy into the tank and gradually revived economic growth.

At some point, the Fed knew well, all that extra cash has to come back out of the economy.

Now taking excess liquidity out of an economy is never simple. And circumstances have combined to make it especially tricky for the Federal Reserve right now.

• First, this flood of liquidity wasn't the first time that Alan Greenspan's Federal Reserve had poured cash into the economy. It did the same to head off the Asian currency crisis, to avert the Russian debt crisis and to prepare for a Y2K crisis that never arrived. The Fed has never mopped up the cash left over from those rounds of crisis management. So, the post-stock bubble round of liquidity was like pumping more water into an already partially flooded basement.

• Second, for reasons that I still can't fathom, Greenspan told Washington politicians that the huge federal deficits that resulted when Congress passed the Bush tax cuts and massively increased spending weren't a big problem. That left the Fed using monetary policy to take cash out of the economy to slow growth and temper inflation while the Washington politicians were using fiscal policy to stimulate the economy.

• Third, the Federal Reserve wasn't the only source of abundant cheap money in the world. In Japan, for instance, short-term interest rates were even lower than in the United States as that country tried to end a decade of no growth and price deflation. This allowed international traders to borrow Japanese yen at 1% with 5-to-1 or higher leverage and then put the borrowed funds into Icelandic bonds, U.S. Treasuries, copper futures or Indian stocks, which pushed up asset prices around the world and created a number of mini-bubbles. (Some of those have been popped in the correction, but others still wait the application of the pin.)

No wonder then that U.S. bond and stock markets are worried that the Federal Reserve will go too far under the untested leadership of a new chairman, Ben Bernanke, who is allied with a new Treasury Secretary, Henry Paulson, with a reputation as an enemy of fiscal deficits. In their efforts to de-stimulate the economy by making money scarcer and more expensive, the bankers of the Federal Reserve could wind up making money too scarce and too expensive. That would slow growth just when the stock market needs expectations of high future growth to support stock prices against a backdrop of rising interest rates.

Which is exactly the same kind of growth slowdown that could happen if central banks in Japan, Europe, India and China make a mistake. I can't remember a time when all the world's central banks faced the same dilemma. The coincident timing certainly explains why all the world's financial markets are moving together in their worry right now.

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