STOCK MARKET WATCH -- Wednesday, 1 August 2012

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22. Confidence drains away

http://www.atimes.com/atimes/Global_Economy/NH02Dj02.html

The continual stream of bad news coming out of Europe is causing a withdrawal of investor confidence in the bonds of several European countries, very reminiscent of the draining confidence in housing-related bonds in 2007-08. Thus there seems to be an increasing likelihood of an extreme scenario in which confidence disappears and insolvency events occur that were previously unthinkable.

Such a collapse in confidence would almost certainly produce a global depression of 1930s magnitude. It's also pretty clear from the 2008 experience that the authorities have little idea of how to prevent this or of what to do when it happens.

This can be easily demonstrated by examining the authorities' behavior in 2008. In monetary policy, Ben Bernanke's Federal



Reserve and the Bank of England both violated Walter Bagehot's famous dictum that in a crisis the central bank should make money readily available against first class security at a very high rate.

The purpose of doing this, as Bagehot and his contemporaries well knew, was to prevent a liquidity crisis that might destroy confidence and cause banks to be forced into liquidation unnecessarily, while at the same time providing a strong incentive for the banking system to get its house in order, foreclosing on loans with poor security, liquidating positions even at a loss and freeing up the banks' balance sheets for future opportunities.