Wednesday, January 23, 2008

Summers Points at Central Banks on Asset Declines (Update1)

By John Fraher and Simon Kennedy

Jan. 23 (Bloomberg) -- The U.S. Federal Reserve and other central banks are partly to blame for the financial-market slump that's now threatening to derail the global economy, said investors and former policy makers at the World Economic Forum.

``It's hard to give central banks a very high grade over the last couple of years on recognition of bubbles and actions taken to address them in the policy or regulatory spheres,'' said former U.S. Treasury Secretary Lawrence Summers in a panel in Davos, Switzerland. Billionaire investor George Soros said central banks have ``lost control'' of financial markets.

The Fed, which yesterday announced its first emergency rate cut since 2001 as U.S. recession fears rose, has been criticized for paying too much attention to economic growth and not enough to so-called asset price bubbles. By cutting rates to protect growth when bubbles burst, the Fed only encourages investors to take bigger risks in the future, said Morgan Stanley's Stephen Roach.

``It's a dangerous, reckless and irresponsible way to run the world's largest economy,'' said Roach, chairman of Morgan Stanley in Asia, who was also in Davos.

The U.S. central bank yesterday cut its benchmark rate by three quarters of a point to 3.5 percent a day after the MSCI World Index fell 3 percent, the steepest decline since 2002. U.S. stocks dropped for a sixth day today, the longest losing streak since April 2002.

Mortgage Bust

Fed Chairman Ben S. Bernanke is facing the same objections leveled at his predecessor, Alan Greenspan, who was slammed for not doing enough to prevent the Internet stock boom and then cutting rates too low to limit the fallout.

In 2003, the Fed reduced its benchmark to a 45-year low of 1 percent, leading to a house-price boom that turned to bust in 2006. That prompted a collapse in the market for mortgages to risky borrowers. It's now derailing financial markets because so many banks bought derivatives linked to those mortgages.

``Central banks lost control of the situation when they allowed financial institutions to develop new financial instruments which they themselves didn't understand,'' said Soros.

Too Difficult

Greenspan and Bernanke counter that it's too difficult for central banks to spot bubbles before they emerge and raising rates to curb higher housing or stock prices would risk derailing the rest of the economy.

Nor was the Fed alone in slashing rates at the start of the decade. The ECB cut its benchmark to 2 percent in 2003, the lowest since the aftermath of World War II, and the Bank of England reduced its key rate to a 48-year low.

While house prices surged in the U.K., Spain and Ireland, those booms have now withered as contagion from the subprime collapse spreads.

Some Davos attendees came to the Fed's defense, saying it's difficult to identify bubbles and more attention should be paid to better regulation.

``We could pierce bubbles but we'd pierce a lot of non- bubbles and take a lot out of gross domestic product,'' said John Snow, also a former Treasury Secretary and now chairman of Cerberus Capital Management LP. ``We need to reform regulation.''

The ECB nevertheless argues that it may be possible for central banks to ``lean against the wind'' by raising rates in the early stage of a bubble to head off future gains.

``It's good for a central bank to ease when the risks are of a crash in the global economy, but that means you have to have a more systematic approach to asset bubbles,'' said Nouriel Roubini, founder of New York-based Roubini Global Economics LLC, in Davos. ``If we have a `Greenspan put' or a `Bernanke put,' then we will create over and over again a distortion of excessive debt and leverage.''

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