How do you shrink the house of cards? Markets for the week ending 16-Jan-08

The FT economists forum was quite interesting this morning and I thought it was quite a good idea to put that in perspective with what the governments are adopting to deal with the current crisis.

Q: With the US official interest rate at close to zero, is monetary policy running out of ammunition?
People are confusing the 'level of interest rates' with the 'rate of change of the interest rates', hence are focusing on America's inability to lower interest rates further.
But cheap money itself provides a strong incentive to borrow and spend and raise discounted cashflow calculations of asset values
However,
1) There is an imperfect linkage between the official interest rates and the actual range of borrowing rates offered in the market
2) Borrowers further out in the yield curve, which hasn’t fallen as much has less to benefit (10-year US Treasury rates has fallen only 2% compared to the Fed fund rates which has fallen 5%)
3) Banks may not be in a position to lend for various reasons such as shortage of capital, dissapearance of commercial credit market

So, can ZIRP (zero interest rate policy) help ?
- Yes:
A) Central banks can push out as much base money (Issuing bonds) as they want to at close to zero rates.
B) Governments can use the money raised to buy longer dated government paper to push down the yield curve to partially address 2) above
C) The money can buy undervalued assets that are clogging illiquid markets from banks and add much needed capital to their balance sheet, addressing 3)
D) The same money can fund expansionary fiscal policies such as improving infrastructure, providing insurance or guarantees to banks and companies

Comments
But the above does not do much to fix the problems happening in the banking sector. The government wants to maintain a flow of lending to help good companies, but how can they distinguish between the good and toxic assets at the micro level.

The UK government has just announced more help for Royal Bank of Scotland this morning but short of nationalising the banking sector in the UK, the regulators are going to find their hands tied on how to shrink the banking sector to a realistic size while not fully recognising the large amounts of mis(over)-priced illiquid assets still sitting in the banking books of financial institutions that have yet to be marked to market.

Something positive
On hind-side for UK, not being part of the Euro might just turn out to be a blessing this week as the European nations in the EU battle to rescue crumbling credibility of the Euro as the Irish economy worsens and Spain's soverign rating downgrade from AAA to AA+. At the rate this continues, it is not impossible to predict a default of posibly a large European economy. (Other at risks: Greece , Italian Portugal)

Eric Tan, London