Key Points:

The United States financial crisis will get much more serious, the Federal Reserve has little ammunition left and the kind of measures that would help are unlikely to appeal to the Bush Administration, says economist Joseph Stiglitz.

Stiglitz, who won the Nobel prize in economics in 2001, is a former chief of the Word Bank and chaired President Bill Clinton's council of economic advisers.

He was in Auckland yesterday to deliver a seminar at the University of Auckland Business School.

The financial markets have been calling for the Federal Reserve to slash the Fed funds rate by another 100 basis points overnight to 2 per cent. The bank has also in the past week implemented further sweeping moves to boost liquidity and bailed out Bear Stearns, a large investment bank.

"The Fed can keep the system from collapsing but it can't get the banks to lend - to each other or to the market," Stiglitz said.

His recipe would be to stem the bleeding from the bottom by bailing out the people who have been encouraged to take out injudicious loans but now face losing their homes.

He thinks it is unconscionable that the shareholders of Bear Stearns will walk away with US$250 million ($310 million), especially if the remaining assets of the bank turn out to be garbage.

"We have mechanisms to bail out the system without bailing out the banks," he said.

Stiglitz expects the situation to get much more serious as a vicious circle develops with banks husbanding their resources, restricting lending and deepening the downturn.

A series of interest rate cuts and liquidity-boosting moves by the Federal Reserve and other central banks has so far failed to persuade markets that they have touched bottom.

Some commentators such as Paul Krugman have started to worry about the risk of a Japanese-style liquidity trap where interest rates get so low that monetary policy ceases to have any traction

Calls for the US Government to take action have intensified.

But the only fiscal measures so far - notably a US$150 billion stimulus package - were too little, too late and badly designed, Stiglitz said.

The Bush Administration had vetoed more effective moves, like increasing unemployment insurance to stimulate demand.

It might be useful to have a public body buying up property left vacant by the housing market collapse in order to underpin house prices, he said.

But that idea had been vetoed too.

Stiglitz's latest book is a scathing attack on the Iraq war and puts a figure of US$3 trillion on its ultimate cost.

He sees parallels between Washington's Iraq adventure and Wall St's innovations which have led to the current turmoil in the financial markets: a kind of recklessness and hubris, a readiness to offload costs and risks on to other people, and an indifference to the human cost.

"There are a lot of parallels."

FOCUS ON INFLATION 'A MISTAKE'

The Reserve Bank's exclusive focus on curbing inflation is a mistake, says Joseph Stiglitz.

"It's exactly the wrong mandate, especially at this juncture," he said.

"In a small open economy quite often raising interest rates is counter-productive because it induces a flood of capital into the country and doesn't have the dampening effect it would have in a closed economy."

It is also ineffectual if the inflation is imported, like when it reflects high international prices for oil and food.

"Raising New Zealand interest rates will have no effect whatsoever on Saudi oil production."

Stiglitz prefers the US Federal Reserve's dual mandate which includes employment (and by extension economic growth) alongside inflation.

He also questions the wisdom of having almost all the country's banks foreign-owned, seeing it as a potential risk to stability in the supply of credit if the parent banks get into difficulties.

"I don't think countries should turn over control of the supply of credit to international markets."

He is not advocating a return to an insular economy. "But at least part of the system should be deeply rooted at home."

The current devaluation of the US dollar might be necessary, in light of the large trade and current account deficits the US had built up, but it had the effect of spreading a lot of the cost of adjust-ment to other countries, Stiglitz said.

"US problem do become the world's problems."