Bernanke Agonistes

Every Chairman of the Federal Reserve Board of Governors in the “modern” era (beginning with the forced appointment of Paul Volcker by Jimmy Carter in 1979, since which time the Chairman has exerted his independent authority) has faced a crisis. Volcker’s was simply beating back the squawking politicians as he took the drastic but necessary steps to clean up the financial mess the ’70s had become.

Greenspan faced the huge uncertainty over the “Millennium bug” or “Y2K.” That the fears of worldwide meltdown over computer programs unable to register the new date were vastly overblown was entirely irrelevant. In the markets, problems most often occur not because of what happens, but rather due to the fear of what might happen. Greenspan acted to alleviate fears over what might happen to the banking system by flooding the economy with liquidity. It worked. (That he later may have triggered a mild recession by trying to squeeze the excess cash out of the system too quickly was a small price to pay for avoiding a panic).

Now it’s Ben Bernanke’s big test, as the fears of high default rates in the subprime mortgage sector have spooked financial markets. The Dow Jones Industrial Average, the NASDAQ composite, and the Standard & Poor’s 500 index have all lost 10% of their value over the last 30 days. For perspective, the DJIA lost 17% of its value in the 30 days preceding Black Thursday in 1929.

The first question Bernanke must resolve, of course, is whether or not to intervene.

There are good arguments for both courses. In favor of standing pat, we have the fundamentals. The economy is strong, growth is steady, even basic materials are rebounding well (usually a sign that construction will follow). Inflation is well contained. Consumer spending hasn’t plummeted as some had feared. The current crisis resulted from the overly optimistic actions of some borrowers, lenders, and investors, and they ought bear the brunt of their foolhardiness. In this camp of the Reaganesque “Don’t just do something – stand there!” falls the estimable George Will, writing in the Washington Post:

But this, too, is true: Every improvident loan requires an improvident borrower to seek and accept it. Furthermore, when there is no penalty for folly — such as getting a variable-rate mortgage that will be ruinous if the rate varies upward — folly proliferates. To get a mortgage is usually to commit capitalism; it is to make an investment in the hope of gain. And if lenders know that whenever they go too far and require inexpensive money the Federal Reserve will provide it with low interest rates, then going too far will not really be going too far.

In 2008, as voters assess their well-being, several million households with adjustable-rate home mortgages will have their housing costs increase. Defaults, too, will increase. That will be a perverse incentive for the political class to be compassionate toward themselves in the name of compassion toward borrowers, with money to bail out borrowers. If elected politicians controlled the Federal Reserve, they would lower interest rates. Fortunately, we have insulated the Federal Reserve from democracy.

The Federal Reserve’s proper mission is not to produce a particular rate of economic growth or unemployment, or to cure injuries — least of all, self-inflicted ones — to certain sectors of the economy. It is to preserve the currency as a store of value — to contain inflation. The fact that inflation remains a worry is testimony to the fundamental soundness of the economy, in spite of turbulence in a small slice of one sector.

The whole article is at the link above. I would only disagree with the last statement that the Fed’s mission is “to contain inflation.” A better description of the FRB’s duty is “to ensure adequate currency to the economy without igniting inflation.” While the modern-era strong Chairman was born of runaway inflation, and containing it has certainly been the goal ever since, we do and should tolerate inflation at low levels because it always beats the alternative – but that’s another post. The primary mission is to ensure adequate currency.

There are several ways the FRB could act to counter the market panic without necessarily bailing anyone out. They could, of course, lower interest rates, which are probably a bit on the high side now (in keeping with the self-image of the Fed as inflation-fighter). They could also buy the sound private bonds on the market as a symbol of trust – the good loans aren’t going south, and the subprime mortgage defaults constitute only a tiny proportion of the home mortgage market. This would undoubtedly allay much of the fears.

Lastly, they could amend the regulations to foster more private capitalization by loosening restrictions. “Whoa, there,” you might say, “why would we react to over-optimistic financing by further loosening?” It may seem counter-intuitive, but that’s the way markets function. Resources flow naturally to their most efficient use; regulations often obstruct the flow.

On this side of the question stands Larry Kudlow of National Review:

Economists David Malpass and John Ryding at Bear Stearns believe second-quarter GDP will be revised up from 3.4 percent to over 4 percent, while third-quarter GDP will come in at a minimum of 2.5 to 3 percent. So, despite the fact that stocks have hit an air pocket and credit markets are suffering a temporary power outage (to borrow a term from economist John Rutledge) the country is not plunging into recession.

That said, the financial liquidity squeeze triggered by the sub-prime virus is a very difficult near-term problem.

Everyone’s watching the Fed, and markets are strongly signaling a Fed ease. Supply-sider Paul Hoffmeister, chief economist at Bretton Woods Research and a former staffer to the late Jude Wanniski, believes a Fed ease would help spur economic growth. What’s more he thinks the added liquidity will bring more bidders to the mortgage credit market, while added growth at the margin will mop up some of the inflationary pressures visible in $670 gold.

Read it all at the preceding link. The danger of doing nothing lies with the herd mentality of markets in stampede mode. Many sound financial institutions could be swept up in the crisis of confidence even though they maintain a strong portfolio with a low and acceptable level of “problem loans.” That wouldn’t be good for the economy in either the long or short run.

I tend to agree with Kudlow that some action is called for. While Will also makes sound points, there is no benefit to watching the house burn down if pumping some water could save it.

Padilla: Guilty
Who is SSGT Lawrence Dean?