One Big US Investment Bank 'Will Go Under'

Source : The Business Times, August 20, 2008

US economy has not seen the worst, says former IMF chief economist

The worst is yet to come for the US economy, which is likely to see more bank failures, including the collapse of a big Wall Street investment bank, said Kenneth Rogoff, a former chief economist at the International Monetary Fund yesterday.

And as policymakers around the world try to prop up slowing economic growth by keeping interest rates low, inflation will become harder to control, he warned.

The US financial sector has grown 'bloated' and needs to shrink before the broader economy can make a full recovery, he said. As it contracts, more financial firms will fail.

'We're going to see one of the big investment banks go under,' he predicted.

Mr Rogoff, an economics professor at Harvard University, was speaking yesterday at a conference on market liquidity and its implications for the world economy, held here.

With falling house prices, a weakening labour market, and poor consumer confidence, 'the red lights are blinking - the US is going to experience a major financial crisis', he said.

Despite the extensive damage already suffered by the banking sector in the US, the crisis is only 'halfway' through, he said. 'I'd go further and say that the worst hasn't come.'

Banking crises 'don't happen out of the blue, they happen because the economy's slowing down', he added.

Just last month, US Treasury Secretary Henry Paulson led a government rescue of mortgage finance giants Fannie Mae and Freddie Mac, promising that the US Treasury and other government agencies would provide liquidity and capital funding to the firms, if needed, to keep them afloat.

And in March, the US Federal Reserve extended emergency funding to investment bank Bear Stearns, paving the way for its takeover by bigger rival JPMorgan.

'I was very disturbed by Hank Paulson's bailout of Fannie Mae and Freddie Mac,' said Mr Rogoff. Like several other critics, he believes that the rescue has merely delayed a necessary consolidation in the US financial sector, which will see unviable companies collapse. Both firms should be taken over by the government and eventually broken up, he added.

State-owned investment funds, which have poured billions of dollars into US and European banks since the crisis in the US housing market erupted last year, will not be able to stop all banks from failing, he said. 'You can't save them all.'

Unlike some other economists, Mr Rogoff does not believe that the economic slowdown in the US, Europe and Asia will be enough to cap surging price inflation, unless governments and central banks tighten their monetary policy significantly.

'The underlying money growth that's taken place over the last few years is going to lead to sharp inflation in the US, Asia ... many parts of the world are going to have inflation for two or three years at least, until they sharply raise interest rates.'

'I don't think recession is going to make inflation go away - interest rates are just too low.'