US interest rates are now officially at zero, and for countries linked to the dollar - including the UAE - this raises long-term policy implications. Economists who had predicted that we would reach this stage had been greeted with ridicule, but zero rate levels are now being wearily accepted by all. No amount of government bailouts and credit injections into financial systems seem to have restored a semblance of confidence. So, interest rates were slashed to the bone and now we ask, what next?
Hindsight is wonderful and everyone now appears to accept that the global financial system has run out of control. A massive debt-fuelled binge resulted in an asset bubble burst, leading to an economic crisis of massive proportions. Add to this volatile cocktail a mixture of greed, some regulatory incompetence - à la the Madoff fiasco - and it is no wonder that people are stashing cash under their beds.
While recession is deepening with increasing vengeance for most countries, the name of the game is now damage limitation to avoid entering into another, more dangerous, Great Depression. This time around, unlike in the 1930s, globalisation will ensure that the poorest economies will be hit the hardest with enormous social and political upheaval. The street riots in Greece, Sweden and once-peaceful Iceland are a taste of what might happen if policymakers do not quickly come up with drastic economic solutions.
In these desperate times, some desperate measures are indeed being taken, and the US Federal Reserve's move to zero interest rates to avoid deflation and a deepening recession is one such measure. The American central bank is looking back to analyse what policies were taken by the president Franklin Roosevelt in the 1930s as a remedy for the 21st-century crises. The Fed has indicated already that zero/low-level interest rates could be around for quite a while, which makes uncomfortable news for the dollar and countries with oil surplus investments, which are already hard hit by a fall in oil prices. This raises the question of how long such countries can continue to support existing expenditure patterns in the face of rising domestic expectations.
The Fed is now going to pursue a series of unconventional confidence and liquidity building measures, having realised that in these extraordinary circumstances Lord Keynes was right all along concerning the use of short-term interest rates. According to Keynes, such interest-rate dependent monetary stimulus policy was like "pushing on a piece of string". The policy to be adopted now is of prodding with a long and thick stick. It is called printing money through the purchase of government bonds and injecting money into the system. The objective is simple, although the outcome might not be so certain. The aim is to drive down long-term borrowing costs for home loans and struggling businesses.
The need for such drastic, unconventional measures stems from the state of the US economy, which is expected to have contracted at an annual rate of about 5 per cent before the end of last year and to face a follow-on period of deflation, or falling prices. It took Japan about 10 years to escape its deflationary phase in the 1990s, and the thought of this happening in the US for any lengthy period is causing acute anxiety in an interlinked world economy.
The Fed's zero-rate policy is set to be copied by others from Japan to Britain, and already there is pressure on the pound after the Bank of England cut rates to their lowest level in three centuries and adopted a money supply injection approach. That policy, however, may sow the seeds for future crises as unconventional methods are not guaranteed to work. By making borrowing cheaper, we could see the beginning a new speculative cycle, once economies boom. Substituting what was in essence speculative bubbles in financial derivatives and bonds with a bubble in the housing market will be the future scenario. There will be a surge in inflationary pressure, once economies turn around. Some historians have noted that it was massive rearmament programmes in the US, Germany and Britain that took them out of the deep recessions of the 1930s, and not civil public projects. Let us hope this option is not the "unconventional" stimulus that will get economies going again.
The implications for the Gulf are serious. Regional interest rates and repo rates are coming down in line with cuts in dollar rates. Inflationary pressures are still inherent in the GCC, despite falls in basic commodity prices, and the region's governments are pumping liquidity into their economies to stimulate demand. Once US interest rates start to rise again, then a more severe inflationary bout will be in store for the Gulf, unless some modest currency diversification is adopted for their unified or non-unified currencies, to provide a measure of semi-independent monetary policy.
Dr Mohamed A Ramady, a former banker, is a visiting associate professor in the finance and economics department at King Fahd University of Petroleum and Minerals in Dharhan, Saudi Arabia
