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Depression risk might force U.S. to
buy assets
By John Parry
13/02/08 -- - NEW YORK (Reuters) - Fear that a hobbled banking
sector may set off another Great Depression could force the U.S.
government and Federal Reserve to take the unprecedented step of
buying a broad range of assets, including stocks, according to
one of the most bearish market analysts.
That extreme scenario, which would aim to stave off deflation
and stabilize the economy, is evolving as the base case for
Bernard Connolly, global strategist at Banque AIG in London.
In the late 1980s and early 1990's Connolly worked for the
European Commission analyzing the European monetary system in
the run up to the introduction of the euro currency.
"Avoiding a depression is, unfortunately, going to have to
involve either a large, quasi-permanent increase in the budget
deficit -- preferably tax cuts -- or restoring overvaluation of
equity prices," Connolly said on Monday.
"If conventional monetary policy is not enough to produce that
result, the government may have to buy equities, financed by the
Fed," Connolly said.
Legal changes would be needed to give the Federal Reserve and
the U.S. government the authority to buy stocks. Currently the
Federal Reserve can buy only debt issued by the Treasury, as
well as U.S. agency debentures and mortgage-backed securities.
While Connolly already sees some parallels with the 1930s, he
expects that a more pro-active central bank and government will
probably help avert a repeat of that scenario today.
The build up of a credit bubble in recent years was similar to
the late 1920s run-up to the Great Depression, he said.
Then, investors were very optimistic about new technologies, and
stocks rose against a backdrop of low inflation, and a trend
toward globalization. There was even an equivalent of the modern
day subprime mortgage debt meltdown in the form of U.S. loans to
Latin American countries which had to be written off.
"The big difference is the attitude of central banks and
specifically the attitude of the Fed," Connolly said.
Some economists have blamed the U.S. economy's travails in the
1930s on the Federal Reserve's hesitation to inject reserves
into the banking system.
However, today's Fed has tried to preempt the danger of a
protracted economic slump and has responded swiftly to a credit
crunch in the past year and gathering signs of deterioration in
the economy, Connolly said.
The Fed has stepped up its temporary additions of reserves to
the banking system, and swiftly slashed its benchmark fed funds
target rate to 3.0 percent from 5.25 percent in September.
Analysts expect at least another 0.5 percentage point cut in
next month.
At the same time, "the fed funds rate can't stay significantly
above the 2-year note yield," Connolly said.
On Tuesday, the 2-year Treasury note yield was at 2.00 percent,
not far above the lowest level since 2004.
The Fed "almost certainly" has to cut the funds rate to 2.0
percent by the end of this monetary easing cycle, he said. If
conditions in the banking sector worsen, the Fed could cut the
funds rate to 1.0 percent, a low last seen in June 2004.
Global banks have already written down more than $100 billion of
bad debts associated with the U.S. subprime mortgage debt
meltdown and housing market decline.
However, Fed rate cuts alone are unlikely to avert a prolonged
period of economic weakness because the danger still exists that
a burdened banking sector will choke off credit to consumers and
households.
"The Fed probably can't fix it all on its own now," Connolly
said. "There is a chance the Fed gets forced into unconventional
cooperation with government," which could involve buying a range
of assets to reflate their value.
That would be reminiscent of some steps the U.S. government took
in the 1930s when the economy was mired in deflation and high
unemployment.
One turning point came when agricultural prices were restored to
their pre-slump levels, Connolly said. Such measures were among
the New Deal programs that President Franklin D. Roosevelt
launched to bolster the economy.
Either way, investors face bleak prospects now without some kind
of further government intervention, he said.
Those steps might offer clues to investors in stocks and
commodities, which Connolly expects the government might be
ultimately force to step in and buy to stabilize markets. He
expects that a depression may be averted, but only by the state
and the Fed reinflating the price of such assets.
Beleaguered housing, non-government fixed-income securities and
even the now overvalued Treasury market have little hope of
generating substantial returns for investors over the next few
years, he said.
"If we don't avoid depression, the only thing worth holding is
cash," he added.
(Reporting by John Parry; Editing by Tom Hals)
© Reuters 2007. All rights reserved.
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