By Ambrose Evans-Pritchard in Davos
27/01/08 "The Telegraph" -- - The United States is sliding towards a dangerous 1930s-style "liquidity trap" that cannot easily be stopped by drastic cuts in interest rates, Nobel economist Joseph Stiglitz has warned.
"The biggest fear is that long-term bond rates won't come down in line with short-term rates. We'll have the reverse of what we've seen in recent years, and that is what is frightening the markets," he told the Daily Telegraph, while trudging through ice and snow in Davos.
"The mechanism of monetary policy is ineffective in these circumstances. I'm not saying it won't work at all: it will help the banking system but the credit squeeze is going to go on because nobody trusts anybody else. The Fed is pushing on a string," he said.
The grim comments came as markets continued to suffer wild gyrations, reacting to every sign of contagion spreading to Europe, Asia, and emerging markets.
Wall Street has begun to stabilize on talk of a rescue for the embattled bond insurers, MBIA and Ambac.
The Fed's 75 basis point rate cut allows the banks to replenish their balance sheet by borrowing at short-term rates and lending longer term, playing the credit 'carry trade', hence the 9pc rise in the US financials index yesterday. But confidence remains fragile.
Professor Stiglitz, former chair of the White House Council of Economic Advisers, said it takes far too long for monetary policy to work its magic. This will not gain much traction in the midst of a housing crash.
"People have been drawing home equity out of the houses at a rate of $700bn or $800bn a year. It's been a huge boost to consumption, but that game is now up. House prices are going to continue falling, and lower rates won't stop that this point," he said.
"As a Keynesian, I'd say the biggest back for the buck in terms of immediate stimulus would be unemployment assistance and tax rebates for the poor. That will feed through quickly, but set against the magnitude of the problem, even a fiscal stimulus package of $150bn is not going to be enough," he said
"The distress is going to be very severe. Around 2m people have lost all their savings," he did.
NASDAQ president Bob Greifeld expressed a rare note of optimism at the World Economic Forum, predicting a swift rally as the double effects of the monetary and fiscal boost lift spirits.
"I think the stimulus package that's been proposed by the President, to the extent that this is passed in rapid fashion by Congress, has the ability to forestall a recession," he said.
"At the moment, our business is doing better than it ever has because the volumes have been incredibly high. So, it's been very good for us," he said.
There were scattered signs of improvement across the world today, with Germany's IFO confidence index defying expectations with a slight rise in January. Japan's quarterly export volume held up better than expected.
Even so, the global downturn may already have acquired an unstoppable momentum, requiring months or even years to purge the excesses from the bubble.
Professor Stiglitz blamed the whole US economic establishment for failing to regulate the housing and credit markets adequately, allowing huge imbalances to build up.
"The Federal Reserve and the Bush Administration didn't want to hear anything about these problems. The Fed has finally got around to closing the stable door (on subprime lending), but the after the horse has already bolted," he said.
© Copyright of Telegraph Media Group Limited 2008