The Federal Reserve Board is now center stage in economic policy
as it performs triage on the financial markets today and faces
building inflation pressures tomorrow. At best, the overall U.S.
economy has entered a period of slow growth; or it may be teetering
on the edge of recession if one is not already at hand. Two major
sectors of the economy--housing and financial markets--are in
severe recession, and it is unclear whether other elements of the
economy, especially business investment and the health care and net
trade sectors, will be sufficient to stave off an overall
contraction.
While the underlying fundamentals of the economy strongly
suggest a recovery and a return to robust growth, the length and
depth of this period of weakness is unclear and will depend
significantly on the actions of the Federal Reserve in the days and
weeks ahead.
Bear Stearns: Buyout, Not Bailout
The Fed is to be commended for showing initiative in recent
months in taking aggressive, timely, and innovative actions to keep
financial markets operating in very difficult circumstances. A good
example is the Fed's husbanding over the weekend of the sale of the
investment firm Bear Stearns to J.P. Morgan. In this event, the Fed
properly used it powers to fold an investment bank whose weakness
posed a potential risk to the financial system.
Bear Stearns faced two choices going into the weekend: a
takeover or bankruptcy. Bankruptcy would have led to great
disruption for Bear's customers and financial markets generally. A
takeover, in this case by J.P. Morgan with support by the Fed and
the Treasury Department, preserved services for Bear's customers
and helped calm the markets. In neither case, however, has there
been any sort of material bailout, as Bear's stockholders are left
with almost nothing.
Fed Innovations Target Liquidity
In a further innovation, this past weekend the Fed established a
new Primary Dealer Credit Facility. This will allow the Fed to
offer liquidity assistance directly to certain major investment
banks that were previously ineligible. The move signals the Fed's
ability and determination to support these investment banks as long
as they remain economically viable, thus averting a potential panic
in the financial system.
The shift in roles with the creation of the new Primary Dealer
Credit Facility is important. In more normal times, the Fed would,
with changes in the Fed Funds rate, content itself with ensuring
that the financial system has sufficient liquidity to work through
its troubles. More recently, the Fed has ensured that specific
troubled markets, such as those for commercial paper or
mortgage-backed securities, had sufficient liquidity. The new
Credit Facility expands the scope of firms in temporary distress
that may be supported through Fed injections of liquidity.
The combination of the new Facility and the Bear Stearns
purchase constitute a potent one-two policy punch. The Facility
means the Fed will not stand by while an investment banks risk
failure due to liquidity constraints as long as the company remains
viable. The Bear Stearns example means the Fed will act
aggressively to fold such companies with little or no remaining net
worth so as to preserve orderly markets.
Wanted: White Knights
The great uncertainty over the next few days will be whether
those firms that find themselves in similar straits as Bear Stearns
can, with the Fed's help, find similar White Knights in time. As it
happens, many of these firms will be reporting earnings in the
coming week, which should cast a penetrating light on their
financial conditions.
Whether the Fed will be able to husband such takeovers in the
future--as it did with Bear Sterns--will depend in part on whether
there are sufficient pools of unencumbered private capital held by
willing investors. There is plenty of capital "on the sidelines"
earning low returns, but the question will be whether the owners
want, or can be persuaded by the Fed to acquire, significant
portions of these troubled companies. If so, then the turmoil among
the financial institutions will pass; painfully for some, but it
will pass--and with it the threat to the economy. If not...
The Risk of Building Inflation
Pressures
In the months ahead, the Fed has a second task before it in
constraining building inflationary pressures. This task may prove
at least as difficult as navigating the present turmoil; once
again, recession hangs in the balance. Many of the actions by the
Fed and other central banks across the globe involved transactions
in which financial assets held by a bank or other firm were
exchanged for a cash loan over a specified period. These
transactions provide liquidity precisely where it is needed and to
whom it is needed. They also have the advantage of automatically
withdrawing liquidity again upon expiration.
In contrast, the Fed has also aggressively reduced the Federal
Funds rate. This likely has helped financial markets in a general
way, and likely gave a dollop of extra energy to the rest of the
economy. But the low Funds rate has also created a serious risk of
rapidly rising inflation and inflationary expectations. Before
long, the world's central banks will need to act aggressively, and
sooner than they would otherwise choose, to drain this excess
liquidity with some urgency. This will be a very dicey business,
because if the central banks, and especially the Fed, act too
slowly, then higher inflation will take hold; but if they act too
aggressively, they will trigger a classic recession sometime in
2009.
Congress's Role Comes Later
The missing player in the present turmoil is the United States
Congress. Citizens ought to be grateful that Congress is in recess.
If Congress were in session, it would likely feel the ever-present
need to "do something." At this point, any action taken by Congress
would be at best harmless. This is a time to let the
professionals at the Federal Reserve and the other regulatory
agencies do their jobs. There will be plenty of time in the months
and years ahead for Congress to review what occurred and,
hopefully, to review the financial regulatory apparatus and rectify
any shortcomings with respect to transparency and safety while
improving the competitiveness of U.S. financial markets.
J.D. Foster, Ph.D., is Norman
B. Ture Senior Fellow in the Economics of Fiscal Policy and David
C. John is Senior Research Fellow in the Thomas A. Roe Institute
for Economic Policy Studies at The Heritage Foundation.