Editor's
note: ATol correspondents Chan Akya and
Julian Delasantellis have in the past days
forecast that the subprime-inspired credit
crisis would persuade the US Federal Reserve to
take a long, hard look at cutting the Fed Funds
rate. Both argued against such a move.
See: Central banks: Easy virtue, easy
money - Julian Delasantellis (Aug 14,
'07) Asia and the vicious cycle of
bank bailouts - Chan Akya (Aug 11,
'07)
With Wall Street beset by a
crisis of confidence and the
mortgage-backed securities
market seizing up, there is urgent need for an
immediate emergency interest-rate cut by the US
Federal Reserve. This sudden need has also
revealed how today's financial system places
monetary policy in bondage to markets. That system
has evolved over the past 25 years with the Fed's
approval, and the current crisis starkly reveals
need for reform.
An emergency rate cut is
needed to prevent the subprime-mortgage meltdown
from spiraling into a full-blown recession. By
immediately lowering the base cost of credit, a
rate cut could make existing mortgage securities
more attractive to investors and also encourage
continued flows of mortgage finance for the
housing market.
Such continued financing
is critical. In its absence, mortgage availability
will shrink and mortgage rates rise, thereby
deepening the US housing-market slump. That is
likely to trigger additional mortgage defaults and
reductions in construction activity, thereby
perhaps even causing a recession. In this event,
the spiral of credit deterioration stands to
deepen, jumping from the subprime-mortgage market
to the entire US housing sector and the US economy
more broadly.
In response to this threat,
the Fed has already moved to inject significant
temporary additional liquidity into money markets,
in effect lending billions of dollars to banks to
prevent their having to make further asset sales
under distressed conditions. Central banks in
Europe, Japan and elsewhere have done the same.
However, because the costs of recession promise to
be so large, the Fed must also move to cut rates.
Less than two weeks ago, Fed policy was
focused on containing inflation. Now, within the
blink of an eye, the evaporation of confidence
among Wall Street lenders has created conditions
warranting an emergency rate cut to save the US
economy. This power of financial markets is rooted
in a new business cycle that emerged in the 1980s
and which has made the US economy increasingly
dependent on debt to fuel expansions. The creation
of debt in turn relies on highly leveraged
financial intermediaries that package and
repackage loans while promising liquidity they are
unable to deliver. As a result, the system has
become fragile.
Increased financial
fragility is one feature of the new system. A
second and worse feature is that increased debt is
part of a complex for shifting value from the real
sector to the financial sector - a phenomenon
known as "financialization". This increases
profits in the financial sector at the expense of
the real economy. Meanwhile, the new structure
also implicitly compels monetary policy to rescue
the financial sector if it gets into trouble. This
amounts to a policy stick-up whereby the Fed is
forced to provide the getaway car for fear that
not doing so will result in even greater economic
damage.
Today's system places monetary
policy in a double bind. In good times the Fed is
forced to raise interest rates to maintain lender
beliefs that inflation will remain low. Those
beliefs ensure that investors are willing to make
the loans needed to fuel the system. However, the
result is higher interest rates and curtailed
expansions that hold down wages and employment,
thereby limiting the share of productivity growth
going to working families.
In bad times,
such as we are now experiencing, the Fed is
obliged to come to the rescue of lenders for fear
that if they stop lending the US economy will
tank. Moreover, this fear deepens the greater the
level and burden of debts. Worse yet, such
intervention creates a problem known as "moral
hazard" that can aggravate the need for rescues.
Having the Fed intervene to prevent
financial meltdowns tacitly puts a floor under
financial markets. That floor acts as a form of
insurance for investors and speculators who,
knowing that they are protected against large
losses, then channel more funds into even
higher-risk investments and loans. The Fed has
actively promoted the new system through
deregulation. Its claim has been that the risks of
the financial system imploding are less because
risk is spread. That claim is now being shown to
be false.
For two decades, working
families in the US have felt the effects of the
policy head-lock imposed by financial-market
demands for ultra-low inflation. Now, financial
markets are exercising their other demand for
interest-rate cuts to preserve asset values to
prevent recession.
The threat posed by the
current crisis is such that the Fed should meet
this demand. That means immediately cutting rates
and continuing to provide emergency liquidity
judiciously. However, once the storm passes, the
US Congress and the Fed must address the systemic
problems and policy distortions that have been
exposed by the current crisis.
Thomas Palley is the founder of
the Economics for Democratic and Open Societies
Project.
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