Inside Politics – The Policy Exchange newsletter (London), 25 January 2008

There are lots of interpretations of this week’s events in the international stock markets and the Fed’s surprise decision to cut interest rates by 75 basis points. Was it a wise step to calm the markets and avert an imminent recession? Or was it a sign of panic without a realistic prospect of having a beneficial effect on the economy?

Whatever it was, it was only a logical continuation of the Fed’s past policies. For the last decade, the US central bank has followed a strategy which regarded injecting liquidity as the best way to stimulate the economy. This had been the Fed’s reaction to 9/11 and to the end of the dot.com boom in the early years of this century. If this policy worked well then, so why not work now?

The answer is that today’s situation is very different. Indeed, much of the current mess the Fed is hoping to clear up now had been caused by its previous actions.

In 2003/04, US interest rates had been as low as 1 per cent, which fuelled the housing market and consumer demand. But when the US economy picked up again and interest rates had to be raised, this brought an end to that business model. The subprime crisis then revealed how much bad debt had accumulated in the years of cheap’n’easy credit.

As we know, the result was a remarkable loss of trust in the economy, especially between financial institutions. The bubble had burst. But it should not be forgotten that without the Fed’s low interest rates, it would have never developed in the first place.

Now that the markets are going through an – admittedly painful – recalibration, the Fed’s reaction of an emergency rate cut only shows that it has learnt nothing from its previous mistakes. It is like downing a bottle of whisky because you do not want to endure last night’s hangover.

The ‘cure’ is unlikely to work. The markets do not suffer from a lack of cash, but from a lack of trust. It is something which the Bank of England will have to consider, too, when making its rates decision on February 7.

In any case, there is no economic law that says that share prices should never fall. It would be wiser if central bankers stepped back and let the markets clear up the mess that was first and foremost caused by loose monetary policies.