Why rate cuts alone may not be enough?

Paul Krugman has this illustration of how even the co-ordinated rate cuts may not actually end up pumping liquidity.

"in early July 2007, before the crisis, the target Fed funds rate was 5.25% and the rate on 30-day A2/P2 commercial paper — that is, CP issued by less-than-sterling borrowers — was 5.4%. On Monday of this week, the target Fed funds rate was 2%, down 325 basis points from pre-crisis levels, but the CP rate was 5.61% — up from pre-crisis levels".

That the stock markets only briefly responded to the rate cuts, before declining further only underlines the aforementioned sentiment. Further, the spread between yields on safe, three-month government securities and the rate that banks charge one another for loans of the same duration rose to more than 4%, not long after the central banks acted — another indication that financial institutions remain deeply concerned about lending to one another! Such is the risk-aversion driven fear psychosis, fuelled by the negative feedback loop of ever more failures, that has gripped the markets. All these are indications of a classic solvency induced liquidity trap.

The way out of this is to get the confidence back for banks to start lending to each other and to the businesses. Easier said than done! A number of economists, led by Paul Krugman, have called for a Swedish style liquidity injection into the distressed and failing banks by way of picking up equity stakes, effectively nationalizing these entities. Britain appears to be doing precisely this through its 50 bn pound bailout plan that gives the government an ownership stake, through preference shares, in the bailed-out institutions. It also would provide a guarantee of about $430 billion to help banks refinance debt.

In contrast, the US appears to have adopted a route that seeks to buy up distressed assets, in the hope that this would re-ignite the market for these assets and thereby shore up the asset bases and equity values of the issuing firms, and ultimately recapitalize the banking system. This approach suffers from numerous pitfalls, as outlined here, here and here. However, there are enough indications that the Paulson Plan may finally end up being similar to the Swedish and British plans, in so far as it is likely to lead to the government taking stakes in the institutions being bailed out.

But with the economies in both US and Europe lurching towards recession, bailing out financial markets may not be enough. Fiscal stimulus, by way of government spending, unemployment insurance, tax credits for the low income, emergency aid to state and local governments, and even public works may all become necessary and urgently needed.

In the meantime, let us wait and watch how the British financial markets respond once the bailout plan becomes operational and liquidity gets injected.

Update 1
More commentaries on the crisis here, here, and here.

Update 2
Barry Eichengreen calls for massive fiscal stimulus.

Update 3
Takeo Hoshi and Anil Kashyap have this NBER paper analyzing the Japanese bailout plan in the late nineties. They raise their apprehensions about the TARP, "The U.S. bailout plan is similar to the Japanese approach in that it does not clearly identify the capital problem as critical and instead proposes using AMCs to remove distressed assets from bank balance sheets. When Japan used AMCs, their effectiveness was limited in part because they did not purchase enough assets. AMCs did not help recapitalization, either, and Japan had to come up with different mechanisms to use public funds for recapitalization. Both these risks are also present for the U.S. plan."