OPINION:Fear has taken hold in the banking sector as a consequence of its own greed. Soothing words from the Financial Regulator would help, writes Michael Casey
THE CURRENT problems in financial markets and in the US economy are serious, but it seems excessive to make comparisons with the Great Depression of the 1930s. If the US does experience a serious slowdown what are the implications for Ireland?
The first point to make is that growth recessions are normal features of economic life. It is true, however, that the US has been remarkably adept at fending off or minimising recessions over the past 25 years - to such an extent that we are more fearful of them nowadays. This in turn leads to panicked reactions that can exacerbate recessionary tendencies.
The present slowdown is not exactly normal though, in that it is being compounded by extraordinary difficulties in the financial sector.
Because of the subprime fiasco, caused by greedy banks and complacent regulators, banks are now afraid to lend to each other. This, combined with belated caution caused by falling property prices, has led to a credit crunch - ie much less retail credit being provided to ordinary consumers.
Consumer spending was probably going to weaken anyway because when the value of assets (equities and property) falls, people feel less well off and are slower to spend, especially on luxury or discretionary goods. It is mainly via consumer spending that asset markets affect the real economy.
The dramatic difficulties of Northern Rock and Bear Stearns throw the issues into stark relief.
In the good times we forget that banks are badly run and greedy. We assume they are being properly regulated. Bank failures always come as a shock and when they are sold off at a huge discount or nationalised, market investors take fright and panic. The authorities then have to deal not just with the immediate problems but also with adverse psychological consequences.
There probably are more skeletons in the US closet. Estimates of total bad debts centre on a figure of about $500 billion. About half of this relates to subprime; the rest is divided between credit card debt and another toxic product, called credit default swaps.
Since the latter product involves insurance against insolvencies it could lead to more bad debts than predicted if the recession bites hard - because in that case there would be more insolvencies and more bad debts.
It is an appalling mess by any standards. It will cause more uncertainty in the inter-bank market, worsen the credit-crunch and force consumers to batten down the hatches, thus deepening the recession.
Much depends on the Fed (the US central bank) which has to date shown itself to be not just ready to intervene but to intervene in an aggressive manner both by lowering interest rates and by providing liquidity to the seized-up inter-bank market. Its decisions this week show how determined it can be.
While it is unlikely that the Fed can prevent a growth recession in the US, it does seem plausible that its actions will limit its extent and duration.
Although growth recessions in the US tend not to last more than one year, the present one may be somewhat longer than that.
A recession in the US is not good news for Ireland, given our reliance on US direct investment. Moreover the effect of lower interest rates in the US is to weaken the dollar, which worsens the competitive position of our exports. We will have to box clever with our own domestic policies, bearing in mind that we have no control over interest rates or the exchange rate.
The Irish stock market will continue to be hit by perceptions about our banks being unduly reliant on property lending. The fact that our banks hold little, if any, of the subprime toxic products seems to be ignored by foreign speculators who appear to be placing bets on the likelihood of Irish bank shares falling further.
Now would be a good time for the Irish Financial Regulator to make a reassuring statement about the health of Irish banks in general. Otherwise false perceptions will rule the day.
But even if the value of assets (equities and property) held by Irish people fall further, it may not affect consumer spending all that much. This is partly because we are not all that influenced by "paper" profits and losses and because the level of household savings is quite high in this country.
Nevertheless we are looking at a growth recession in Ireland. The ESRI forecast of 1.5 per cent growth this year seems about right, though the recovery might be delayed a little beyond 2009.
Much, however, depends on the Fed. It has done extremely well in the past and although the nature and magnitude of present difficulties are different than before, the Fed has a good track record and, incidentally, employs extremely skilled and experienced people.
The European Central Bank, because of its exclusive inflation mandate, will not be able to make much of a contribution to safeguarding growth. And our own policymakers have not covered themselves in glory in the past.
In a climate of uncertainty one is driven back on basic beliefs. In the medium to long run, financial market volatility doesn't have much influence on the real economy; the psychological effects on consumption tend to wash out.
The other side of that coin is that equity values don't depend all that much on the real economy. The idea that a growth recession is inevitably bad for the financial markets is not borne out by history.
There have been several recessions where equities did well. Money has to go somewhere. At the moment it is going into gold and other exotic commodities.
As real economies slow down there will be less investment in new assets.
At some point the surplus money is going to go back into equities and even into property.
At some point the banks are going to have to lend to themselves and to consumers again.
Life goes on. There is no apocalypse here. Indeed, it can even be argued by the more Puritanical among us that a mild recession every so often is good for the long run health of the world economy. It keeps our feet on the ground.
But banks, financial sectors, and regulators have to be sorted out. We are dealing here with the completely unacceptable face of tooth-and-claw capitalism. The global architecture of bank regulation has to be completely revamped.
We simply cannot continue with a system where appalling decision-making by leading banks contributes to recession and where the awful effects of these decisions hijack central banks and force them to set aside their primary task of controlling inflation.
At the end of the day, if and when the Fed does its damage-limitation by providing even more liquidity and reducing interest-rates even further, the result will be higher inflation in about two years' time.
That, ultimately, may be the price the world will have to pay for the greed of US banks and the complacency of their regulators.
Michael Casey is a former senior official with the Central Bank and a former member of the board of the International Monetary Fund"We simply cannot continue with a system where appalling decision-making by leading banks contributes to recession