The stock market collapsed this week under the weight of forced sales from hedge funds and mutual funds. With the bond markets still dysfunctional, stocks were one of the few assets that could be sold … and sold they were! The major market averages declined by about 18% in one week. Fear and volatility have reached levels that typically occur near the end of market declines. We cannot be certain where the selling will end, but we believe it should subside relatively soon.

Two important policy developments occurred this week. First, the Federal Reserve announced that it would buy commercial paper. This step is vital for purposes of providing short-term funding to major businesses across the country. Second, central banks around the world were able to co-ordinate a reduction in short-term interest rates. The co-ordination was important so that the currency of one nation was not disadvantaged relative to other currencies in other countries.

Had the U.S. cut rates unilaterally, that action could have caused a plunge in the dollar and a spike in longer term interest rates. More interest rate reductions will be needed, but we take comfort that there is some level of international co-operation.

The authorities still need to come up with a mechanism to restore confidence between and among banks. Each fears that it may be lending money to the next Lehman Brothers. As a result, little interbank lending is occurring, a condition that continues to keep the availability of credit severely restricted. We think some sort of guarantee will be created by central banks, a step that should restart the flow of credit.

The longer this credit crunch lasts, the greater the damage to the global economy. The authorities now seem to understand that this is a global problem and are beginning to work together to solve it. Because of the differences in cultures and national interests, co-ordination will not be easy. Nevertheless, we believe that government officials recognize the need and are responding to the riot in the financial markets. They are still behind the curve but are making progress.

Policy actions may not yet be sufficient, but at least the authorities are no longer in denial. We are encouraged by the massive policy response and believe it will eventually succeed.