borrowers to build up equity in their homes, and credit would remain easily available, so that borrowers would be able to refinance if necessary.

Housing markets were not the only ones caught up in the credit boom. The large flows of global savings into the US drove down the returns available on many traditional long-term investments, such as treasury bonds, causing investors to search for alternatives. In line with this, the financial industry designed securities that combined many individual loans in complex ways. These securities were perceived to be safe, however as we are well aware these new securities proved to involve substantial risks – risks that neither the investors nor the firms that designed the securities adequately understood at the outset.

The credit boom began to disentangle in early 2007 when the problems surfaced in the subprime mortgages market (these are mortgages offered to clients that are not economically viable), the house prices that were perceived to continue to grow began to fall in some parts of the US. Mortgage arrears and defaults rose, as such there was a continuous downward trend in housing prices, and this trend still continues today. Investors were dismayed by the downward trend on the investment vehicle that they had perceived to be safe – as such they began to pull back from a wide range of credit markets, and financial intermediaries also cut back their lending. The situation worsened with the bankruptcy of Wall Street investment bank Lehman Brothers and the bailout of the insurer American International Group (AIG). Stock prices fell sharply as investors lost confidence in financial institutions. The economic downturn accelerated and global economic growth fell steeply coupled with a slowdown in international trade. Declining stock values, a grumbling financial system, and difficulties in obtaining credit triggered a remarkably rapid and deep contraction in global economic activity and employment, a contraction that has persisted through the first months of this year. Both the ongoing financial crisis and economic contraction have posed major challenges to policymakers worldwide.


What are Central Banks doing to address the situation?

Central banks and governments in mainly the industrialized world have taken unprecedented actions in their attempts to restore confidence in the financial system. In general the main objective of any central bank is to contribute to financial stability by acting to manage and contain financial disruptions and prevent their spread outside of the financial sector.

Central banks’ basic policy tool for influencing economic activity and inflation is their ability to control the short end of the yield curve – that is they have control over short-term rates. For example the South African Reserve Bank (the Reserve Bank) has control over the repo rate which in turn has a positive relationship with all other rates. The Federal Reserve (The Fed) in the United States have a direct control on federal funds rate, which is the rate that banks pay each other for overnight loans. Lower interest rates can be used to stimulate private-sector borrowing and spending at times like the present when the economy is suffering from lack of demand.

In September 2007, shortly after the turbulence in financial markets began and signs of economic weakness started to appear, the Federal Open Market Committee (FOMC) began to aggressively reduce the federal funds rate. By March 2008, the Fed had cut the federal funds rate to 2 percent, in an attempt to promote the declining economic activity. The demise of Wall Street investment banks has seen the Fed reduce the federal funds rate further down, since December 2008, the US policy interest rate has been essentially zero. In a similar vain, since December 2008, the Reserve Bank has reduced its policy rate by 350 basis points (3.5% percentage points).

In general we have seen significant liquidity injection, lowering of collateral requirements, asset swaps, longer-maturity refinancing operations, intervention in foreign exchange markets, and co-operation among central banks in their market operations, monetary accommodation, quantitative or credit easing, capital injections into banks and other financial institutions, substantial stimulus packages, and in some cases nationalization of banks. Despite all these efforts to stimulate the economy some economies are still going into recession. Economists and market participants are aware that the seeds of the next crisis are sown in the solutions for the current one; currently we are reaping the fruits of the seeds that were sown to counteract the dot.com bubble burst and the events of September 11. As such we need to ask ourselves whether the current aggressive response by the Central Banks, risks inflation down the road.


Does the Central Banks’ aggressive response risk inflation down the road?

Policy interventions implemented now may be the lifeline for the world financial system, but the seeds for the next crisis are sown in the solutions for the current crisis. That is the aggressive expansionary policies evident throughout the world may, inherently, have negative consequences over the long term. The main objective of these Central Banks is price stability – as such Central Banks take this obligation to ensure price stability extremely serious. However the striking feature of Central Bank lending and other government financial support during the current financial crisis is the extent to which it has gone beyond the boundaries that previously were understood to constrain such lending, and that the scope of the financial safety net ultimately must be rolled back.

Currently inflation is not an issue that many people are worried about, though the measures taken currently are potentially inflationary – but inflation is not necessarily bad. We need inflation at an acceptable level; this is the issue that the Central Banks will have to deal with later. At the moment there is need to revive the global economy to come back to acceptable levels. From the regulation school we need to seek a better way forward, for instance are Basle II and other regulatory frameworks the best ways to manage the financial markets prudentially; Regulation can be cumbersome and involved.

Doctors learn from pathologies, surely economists and financial markets participants can and will learn from the economic downturn.

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