Business | Opinion
Fed chose the less bad option in the face of recession
Looked at from a certain angle, the Fed's dramatic (though not unexpected) rate cut last week is a bit screwy.
- Los Angeles Times-Washington Post News Service
- Published: 00:11 January 28, 2008
Looked at from a certain angle, the Fed's dramatic (though not unexpected) rate cut last week is a bit screwy.
After all, what got us into this mess in the first place was too much cheap credit that was used to buy houses, finance corporate takeovers and commercial real estate and speculate in commodities, driving up the price of said houses, takeover targets, office buildings and commodities to levels unsupported by the economic fundamentals.
Now the bubble has burst and the prices of those assets are beginning to fall back to more reasonable levels. Why would anyone want to interrupt that process by bringing back the cheap credit?
The short and oversimplified answer can be summed up in three words: the Great Depression. For that was very much the attitude of the Federal Reserve and other central banks after the stock market crash of 1929. To a lesser extent, it is also the lesson of Japan's bungled policy response to the bursting of its real estate and stock market bubble in the early 1990s. As USA Today's David J. Lynch pointed out in a timely piece on Tuesday, the leading academic expert on both failures is none other than the current chairman of the Federal Reserve, Ben S. Bernanke.
Under Bernanke, the Fed's policy is that it's not in the business of pricking bubbles, which it argues - unconvincingly - are recognisable only in hindsight. At the same time, the Fed stands ready to deal with bubbles when they finally burst and begin to have an impact on the "real" economy. As a practical matter, that means lowering interest rates when turmoil in financial markets threatens to drag the economy into recession, as now seems to be the case.
While it may sound simple, this is, in fact, tricky business. The idea isn't to halt the process by which financial assets and risk are re-priced, which inevitably has the effect of slowing the economy.
On the other hand, these correction processes inevitably unleash irrational behaviour on the part of consumers, investors and businesses that can turn into a vicious cycle of selling that begets selling, failures that beget more failures and that is very hard to stop. When that happens, the recession that follows winds up being deeper and longer lasting than necessary to correct for the past excesses. In the process, many more people are punished than those who made bad bets during the bubble.
At the moment, the Fed's big fear isn't a mild US recession. It is a market meltdown in which the failure of one bank or hedge fund or insurance company triggers another and another as panicked investors and lenders all head for the exits at the same time.
That's what the Fed and other central banks confronted last summer when they flooded markets with short-term credit to overcome the reluctance of banks to lend to one another. And it was what central bankers confronted again this week with the sharp sell-off on nearly all of the world's stock markets, where mounting concerns about a US recession and banks failures and stock market bubbles suddenly converged.
Although Fed officials will claim in public that their three-quarter point rate cut was justified by risk to the economic fundamentals, simple logic tells you it ain't so. There's been nothing that has happened to the real economy in the past few weeks to justify an emergency meeting, let alone the biggest rate cut in more than two decades.
Rather, the Fed's goal was to calm financial markets and take pressure off the balance sheets of troubled banks and insurance companies that benefit when borrowing costs are reduced. And, for the moment at least, it seems to have worked.
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