BETTING THE BANK World Business By PAUL KRUGMAN Published: March 14, 2008 Four years ago, an academic economist named Ben Bernanke co-authored a technical paper that could have been titled âThings the Federal Reserve Might Try if Itâs Desperateâ â although that may not have been obvious from its actual title, âMonetary Policy Alternatives at the Zero Bound: An Empirical Investigation.â Today, the Fed is indeed desperate, and Mr. Bernanke, as its chairman, is putting some of the paperâs suggestions into effect. Unfortunately, however, the Bernanke Fedâs actions â even though theyâre unprecedented in their scope â probably wonât be enough to halt the economyâs downward spiral. And if Iâm right about that, thereâs another implication: the ugly economics of the financial crisis will soon create some ugly politics, too. To understand whatâs going on, you have to know a bit about how monetary policy usually operates. The Fedâs economic power rests on the fact that itâs the only institution with the right to add to the âmonetary baseâ: pieces of green paper bearing portraits of dead presidents, plus deposits that private banks hold at the Fed and can convert into green paper at will. When the Fed is worried about the state of the economy, it basically responds by printing more of that green paper, and using it to buy bonds from banks. The banks then use the green paper to make more loans, which causes businesses and households to spend more, and the economy expands. This process can be almost magical in its effects: a committee in Washington gives some technical instructions to a trading desk in New York, and just like that, the economy creates millions of jobs. But sometimes the magic doesnât work. And this is one of those times. These days, itâs rare to get through a week without hearing about another financial disaster. Some of this is unavoidable: thereâs nothing Mr. Bernanke can or should do to prevent people who bet on ever-rising house prices from losing money. But the Fed is trying to contain the damage from the collapse of the housing bubble, keeping it from causing a deep recession or wrecking financial markets that had nothing to do with housing. So Mr. Bernanke and his colleagues have been doing the usual thing: printing up green paper and using it to buy bonds. Unfortunately, the policy isnât having much effect on the things that matter. Interest rates on government bonds are down â but financial chaos has made banks unwilling to take risks, and itâs getting harder, not easier, for businesses to borrow money. As a result, the Fedâs attempt to avert a recession has almost certainly failed. And each new piece of economic data â like the news that retail sales fell last month â adds to fears that the recession will be both deep and long. So now the Fed is following one of the options suggested in that 2004 paper, which was about things to do when conventional monetary policy isnât getting any traction. Instead of following its usual practice of buying only safe U.S. government debt, the Fed announced this week that it would put $400 billion â almost half its available funds â into other stuff, including bonds backed by, yes, home mortgages. The hope is that this will stabilize markets and end the panic. Officially, the Fed wonât be buying mortgage-backed securities outright: itâs only accepting them as collateral in return for loans. But itâs definitely taking on some mortgage risk. Is this, to some extent, a bailout for banks? Yes. Still, thatâs not what has me worried. Iâm more concerned that despite the extraordinary scale of Mr. Bernankeâs action â to my knowledge, no advanced-countryâs central bank has ever exposed itself to this much market risk â the Fed still wonât manage to get a grip on the economy. You see, $400 billion sounds like a lot, but itâs still small compared with the problem. Indeed, early returns from the credit markets have been disappointing. Indicators of financial stress like the âTED spreadâ (donât ask) are a little better than they were before the Fedâs announcement â but not much, and things have by no means returned to normal. What if this initiative fails? Iâm sure that Mr. Bernanke and his colleagues are frantically considering other actions that they can take, but thereâs only so much the Fed â whose resources are limited, and whose mandate doesnât extend to rescuing the whole financial system â can do when faced with what looks increasingly like one of historyâs great financial crises. The next steps will be up to the politicians. I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care. At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what itâs doing to an angry public.
That's a good point. Out of the three candidates - Mccain, Clinton, and Obama - literally none of them have the first clue about economics. IMO Obama would be the best because he is probably humble enough to realise he has no clue about economics. If his advisors are good his policies could be. Clinton and McCain are arrogant as well as clueless, both would be an economic disaster IMO.
I like the comment New Deal V.2. FDR broke it down into three actions: rescue, relief, and reform. Rescue efforts for the financial institutions are underway, but as the NYT article mentions, the effort is not working. What is the government doing to rescue the consumer/public? Well, the FED's efforts to lower short-term interest rates aren't working. The public is saving some money on their ARM's and home equity lines, but taht savings is being used to pay down other bills; hence, no new consumer spending. The stimulus package recently passed will not work either. People will use that money to pay down their bills; hence, no new consumer spending. Fortunately, the unemployment rate is still historically low; unfortuantely, unemployment is a lagging indicator. Dealings with primary homeowners are insufficient--delaying foreclosures and providing inadequate "new deals" to the borrowers. Freezes have never worked; they just delay the inevitable. Real rescue for primary homeowners with ARMS would be a "conversion" of these ARM's to 30-year fixed rate mortgages at the banks' expense. This type of rescue is cheaper than a foreclosure any day. Relief efforts are not working either. Unfortunately, the GOVT is so busy working on reform efforts that they needed to wait for rescue/relief efforts to work first. Reform is a effort to prevent crises in the future. Licensing of mortgage brokers is a must; crackdown on unfair and predatory lending practices is imperative. I remember when I went to the bank to refinance in 2004. Everyone pushed the option ARM here in Florida. they developed a chart showing the advantages of option ARMS in an exploding upward price environment. Of course, no one presented a chart showing what could happen if housing prices dropped and interest rates skyrocketed. Lastly, the FED foolishly handled the rise of rates in the late 90's, the reduction fo rates in the early 2000's, the maintenance of low rates for too long, and the silly small incremental increases since 2003. Even now, the FED seems to step in when the market is on the verge of crashing. The GOVT must remember that rescue and relief are first and foremost, then reform. Rescue and relief efforts must be fast and adequate. Then reform needs to follow and then interest rates can return to normal as the economy expands. We have these crises because very few economists can accurately forecast in today's global economy.