Limiting the damage

The sub-prime crisis in the United States, which threatens to influence the course of the global economy in 2008, provides a good case study of regulatory failure and also success, and it is important that the right lessons are learnt. For instance, the housing price bubble was well known, indeed serious economists had forecast that the bubble was close to bursting. To some extent it defies logic as to why the authorities did not move sooner to cool the real estate market. As for the financial innovations that led to the bundling of different qualities of assets in a way that became opaque, the US Treasury Secretary, Henry Paulson, has admitted that financial innovation got ahead of regulation and thereby caused the problem. What is odd is that neither Mr Paulson nor Wall Street seems to want any changes here, they would rather leave things as they are.

Meanwhile, the embarrassing truth is that Alan Greenspan, the then chairman of the US Federal Reserve Board, had ignored warnings from within his own system (specifically, from Edward Gramlich, a member of the Board), that the sub-prime problem was present and growing. Speaking in 2004, Mr Gramlich had raised a warning flag when he said: "Increased sub-prime lending has been associated with higher levels of delinquency, foreclosure, and, in some cases, abusive lending practices. On a social level, one question is whether the gains afforded by these new market developments outweigh the losses. Another question is whether anything can be done to limit foreclosures." It should be added that Mr Gramlich's conclusion in 2004 was that the net benefits of ballooning sub-prime mortgages outweighed the negatives, but he has said that he tried to draw Mr Greenspan's attention to the issue as far back as 2000. So this crisis was a long time coming, and it should teach regulators that they should be more willing to intervene in markets than they were in this case.

That said, have monetary authorities have done any better in coping with the crisis after it first hit the headlines about six months ago? The crisis has rolled out slowly, and continues to do so. The worst is not over, and some observers forecast a full-blown recession in the US by the middle of 2008. That grim denouement may or may not come to pass; if it does not, good policy will probably have something to do with it. Whether it is responses through quick changes in interest rates or the pumping in of massive liquidity into the system, in a coordinated action by many central banks, the monetary authorities in the leading economies have moved well and quickly to limit the fall-out of the sub-prime crisis, learning in many cases from mistakes of the past "" including the handling of the Asian crisis of a decade ago, when the International Monetary Fund demanded a tightening of money in countries that should have made money more easily available.

There is of course criticism of the limited and probably ineffective scheme put out a few weeks ago at the prodding of the US Treasury, to try and limit foreclosures; the Bush administration has probably done less than it could have. There is also the inevitable criticism of the way in which the Bank of England did an about-turn while handling the Northern Rock bankruptcy, being prodded by the British Treasury to give up its established position and in effect give a government guarantee on all deposits "" reminiscent of the way in which the Unit Trust crisis was handled here in India nearly a decade ago. But that too provides a valuable lesson in how text-book solutions are often not workable in practice.