Expert View: Our sick markets need treatment – forget the 'moral hazard'

In case it has escaped your attention, we're in one hell of a mess. Money markets are behaving as if a world war were about to break out. High-street banks are refusing to lend to one another, and the difference between official interest rates and the rate on the street is varying in a way familiar to North Vietnam currency traders. The next fortnight will be a crucial test for the global financial infrastructure. Debate centres on what the US Federal Reserve may do, but there is no easy way out of this crisis. We need some innovative thinking.

Economic historians will expend much energy in the future debating just what central bankers should or should not have done to cope with the sub-prime meltdown. The overly prompt action of the European Central bank, suddenly throwing liquidity at the markets in €20bn chunks, actually undermined confidence.

One can therefore understand the more laid-back, some would say haughty, attitude of the Bank of England, which basically allowed sterling markets to look after themselves – "sensible correction, old chap". But even the Bank lost its sangfroid when by mid-week Libor, the crucial benchmark rate, was some 100 basis points above where it should have been.

One market wag observed to me that if the Bank had finally acted, the crisis must be over. If only. He is not alone in seeking some deus ex machina to lead investors safely out of the sub-prime labyrinth.

All eyes are on the crucial Fed meeting on 18 September. What's really going on in the economy is likely to dominate debate, as is the usual dilemma that any rate cuts now will take at least 18 months to have an effect. Rumours abound as to who said what to who at the Fed governors' Jackson Hole retreat. Governor Mishkin apparently argued forcefully for aggressive cuts to stop a housing market debacle. Another economist went further, saying a 50 per cent drop in US property prices was a real possibility. On Wednesday came the news that new home sales had fallen 12.2 per cent, rather than the 2 per cent expected.

Those opposing cuts employ the "moral hazard" argument. When Alan Greenspan was in charge, the markets came to believe that the Fed would always lead them out of any crisis. Eventually, bankers started to believe they were living in a risk-free world – leading to a mispricing of risk. In Ben Bernanke's own words (before he became Fed chairman): "For the Fed to be an arbiter of speculation or values is neither desirable nor feasible."

But as one City economist observed last week, for central bankers to refuse to act in this crisis, citing moral hazard, would be like a doctor refusing to treat a heart-attack patient because of his bad diet. It is naive of those against rate cuts to argue that the cracks in the global financial infrastructure are just markets correcting. Something much more frightening is going on.

There is also every possibility that the restriction of liquidity will continue to drive down housing activity and so depress the economy. Last week the OECD cut its forecast for 2007 US growth from 2.1 to 1.9 per cent.

At the same time, there will be no way out of this crisis until the root cause is addressed. This is not about the US housing market, nor even the inadequate control of lending within that market, but rather the financial engineering that sought to pass risk on. The purveyors of collateralised debt obligations argued that CDOs were a clever way of directing risk to those best able to take it. This is now shown to be false: risk has been passed on to those least able to understand it. The collapse of German bank IKB made this point clear.

A solution to the crisis must therefore feature not just central bank action but a big improvement in disclosure. We need all financial institutions to carry out a forensic examination of the complex instruments they are involved in. Some may have to be dismantled; all must be marked to market. Any off-balance sheet risks must be stated.

It would be best if this were achieved by collective action agreed by industry bodies. But they may need encouragement. Mr Bernanke has the right medicine for the market, but the patient also needs to heal itself.