ThoughtNGine

The Power of Ideas

Where’s the Fire?

If you have read this Blog (or talked with me over time), you would know that I have been critical of policy and policy response from the Federal Reserve (as well as the Treasury).  I often refer to the Fed’s approach as ostrich economics.  Their short-sighted policies have dug us into a fine mess.  Across the entire spectrum, people have been suckered in hook, line and sinker.  This includes the average Joe who over-extended himself to buy the over-sized, over-priced home of his dreams.  Somewhat surprisingly, the list also includes sophisticated investment firms and major financial institutions, several of which have been brought to their knees.

The Federal Reserve, which is given the dual mandate of full employment and price stability, has found itself facing an economic landscape with more craters than the surface of the moon.  Let me list a few: Credit (Check. And not the type lenders do); Leverage (Too much); Liquidity (Not enough); Growth (Hard to find); Jobs (Even more scarce).  It sounds like a bad infomercial.  But wait, there’s more.  How about skyrocketing commodity prices, a collapsing currency and fiscal fissures at all levels of government.

Unable to confront both a deteriorating economy and rising inflation at the same time, the Fed has thrown everything it can think of (including the kitchen sink) to try and prop up the economy and protect our financial institutions.  Inflation is tomorrow’s problem.  Unfortunately, the policy equivalent of the firepower of the U.S. Navy has “barely” put a dent in the surface of the problem.  Only last week, one of our storied investment banks, Bear Stearns, was forced onto life support and then, in historic and questionable fashion, into the arms of JP Morgan.  I have much to say on this latest development, but I will leave it for another time and place.  I do not believe in bail-outs, but it is becoming abundantly clear at this point that there will be virtually no innocent bystanders if this vortex is not stopped.

Although I admit it begrudgingly, the Fed is directing its attention to the core of the problem: The deteriorating condition of our financial institutions.  The Fed, which has aggressively lowered rates and provided innovative financing facilities to financial intermediaries, is concerned with liquidity.  Their solution is reminiscent of the Japanese response to the problems that destroyed that economy twenty years ago.  It is more a “rearguard” action designed to allow time to do the healing.  But if Japan is any example, the healing process is glacial and time is the one thing we do not have.

As is suggested by Bear Stearns, I believe the problem faced by financial institutions is capital, or lack thereof.  Illiquidity and leverage are manifestations of this problem.  It is apparent that these struggling institutions need capital to survive.  Unfortunately, that is not enough.  Mere “survival” leaves our financial institutions in a state of suspended animation.  The economy will probably find itself in the same boat.  If the economy is to regain its’ footing, banks have to be part of the solution.  They will have to provide fresh funding to a wide array of end users, and this requires much stronger balance sheets.

If I were in the Fed’s shoes, I would insist that our major banks and financial institutions raise capital, a lot of capital.  I would also press lender’s to pass on to creditworthy borrowers some of the cost savings being provided by Federal Reserve policy.  Finally, I would try to persuade financial institutions to retain employees, even at the expense of reducing earnings.  To the extent that institutions balk at these suggestions, I would gently remind them that Fed initiatives have helped bottom lines significantly over the last nine months and will do so for the foreseeable future; and these initiatives are being done for the good of the economy as a whole, and not just for bank management, shareholders and debtholders.

One final thought.  In the last three decades, a number of crises have been resolved by Federal bailouts.  I would suggest that when general taxpayer dollars are used to prop up private institutions, taxpayers should also reap the benefits.

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March 25, 2008 - Posted by | Economics, Finance, General Interest, Markets, Politics

3 Comments »

  1. but we know the problem is global.
    if we don’t allow them to fail now they may very well emerge over time with much more control than they already have had.
    the people are put between a rock and a hard place. saving themselves by saving these institutions may sounds easier that letting them fail…but…what is the risk in the longterm?
    i don’t trust these policies now, and don’t plan to in the future either.

    Comment by Jesse | March 25, 2008

  2. I fully agree. As I noted in the piece, I have a lot more to say about government bailouts. They should not happen; but if and when they do, the taxpayers should get the upside. The general philosopy is that people who take risk expecting a profit, also have to bear the risk of loss. If you take government risk, you get government returns.

    Comment by ngrossman | March 25, 2008

  3. I couldn’t agree more! If the government and the fed are going to bail out these financial institutions, they should ask for something in return. If financial institutions are going to be helped in these unprecedented ways they should bear the burden of doing things to support the economy as well.

    Comment by Nathan | April 9, 2008


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