Wise thoughts in unwise times...

In an April 2005 article in The Washington Post newspaper, titled "An Economy On Thin Ice", the former US Federal Reserve Chairman (from 1979 to 1987), Paul Volcker, had given clear hints of the ways he saw the US financial system collapsing under the weight of easy money and housing problems.

Here is what he had written in that article - "The U.S. expansion appears on track. Europe and Japan may lack exuberance, but their economies are at least on the plus side. China and India - with close to 40% of the world's population - have sustained growth at rates that not so long ago would have seemed, if not impossible, highly improbable.

Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.

The difficulty is that this seemingly comfortable pattern can't go on indefinitely. I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change."

A man with his kind of insights could not have been wrong! And he wasn't!

The US banking and financial system is facing a severe crisis - of funds and confidence. Some of the banks and investment banks are going/about to go belly up. And the real economy is not looking good either, with the Americans slowing down on their consumption. While the Fed (US central bank, like India's RBI) is taking steps to douse the fiery sentiment, by way of infusing liquidity in the system and also reducing interest rates, the affect of these measures on the economy will still take some time to get clearly visible.

However, stockmarkets, as they always are, factor in the positives and negatives of news flows as and when they are released. Or what could explain a 3.5% (420 points) rally in the US Dow Jones index and similar gains being recorded by the leading Asian markets following a 0.75% cut in interest rates by the Fed late yesterday. In its monetary policy meeting yesterday, the bank lowered its federal-funds rate to 2.25%, from 3% earlier. Following this, the Fed also lowered its primary credit rate (or discount rate) from 3.25% to 2.5%; just a couple of days after this rate was reduced from 3.5% to 3.25%.

While reducing the federal-funds rate, the Fed has maintained its sober outlook on growth and inflation. In the words of the Fed, "Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters."

On inflation, the monetary policy report states, "Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully."

On the whole, the Fed has put forward its belief that "these policy actions, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity."

The crisis of confidence is exactly what the US and global financial system is facing today, what Volcker had predicted 3 years back.