Monday, July 7, 2008

Risk of Overadjustment

While we must allow the market to adjust, there is the risk of overadjustment in the market as a result of policy interventions.

Property sales in Kuwait fell 36% year-on-year in May, the second consecutive month of decline, as banks were asked to increase the credit credentials of borrowers.

When the price increases, the adjustment is that demand will fall so that demand adjusts to existing supply. The higher price may trigger new supply.

Or, in this case, if the price increase is due to speculation in the global commodity markets, then the decline in demand will create an excess supply which will undermine the speculative assumption.

Either of these adjustments will be nullified if income is increased to maintain the prevailing demand, which will then strengthen the speculative assimption.

If the price increase is due to the depreciation of the US dollar, then the solution is to increase the US interest rate in order to strengthen the currency.

If the local currency is tied to the US dollar which is depreciating, then the solution is to increase the local interest rate to strengthen the local currency, regardless of the US interest rate.

In the Kuwaiti case, the prescription is a credit crunch which is always a nasty pill, as it will unwind instantly the speculative process in the real estate. This applies for all countries that are tied to the US dollar.

Instead of a credit crunch, an increase in the interest rate will give a longer period of adjustment for the private sector.

But, then, there has never been an ordinary exit out of a house on fire.

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