Federal Reserve Chairman Ben Bernanke, like Alan Greenspan before him, has acted to keep a credit crunch from turning into a depression. The stock market liked the Fed's half-point rate cut, and experts have generally praised Bernanke's determination to do whatever it takes to contain the crisis.
But the turbulence is far from over, and in a sense the Fed is cleaning up its own mess. For more than two decades, the Federal Reserve has been the prime enabler of a dangerously speculative economy. If we dodge this bullet without addressing the deeper threats, there will be more bullets to come.
Here's the basic problem: Since the late 1970s, financial institutions have invented exotic ways of extending credit and taking big speculative risks. For example, bonds backed by packages of mortgages are not like traditional bank loans. In a crisis, their value can plummet. Likewise the other derivative instruments heavily traded by hedge funds.
In the old days, bank examiners could look at a bank's portfolio of loans, assign a precise degree of risk, and require banks to hold adequate reserves against losses. Today, much of what banks hold is a financial black box. Nobody knows what this paper is really worth. And just as all this risky innovation was proliferating, Congress made matters worse by deregulating much of the banking sector, reflecting the prevailing view that financial markets could regulate themselves. Up with markets, down with government!
The Federal Reserve, however, is part of the government. And every time one of these new financial fads blows up on its sponsors, in rushes the Fed to countermand the market's verdict because of the larger risks to the economy.
When banks lost billions on Third World loans in the 1980s, the Fed came to their rescue. When Citibank was under water in 1990, the president of the Federal Reserve Bank of New York personally undertook a secret mission to persuade a Saudi prince to pump in billions in capital as a passive investor. Sure sounds like government intervention to me.
In 1998, the Fed virtually ordered the banks to bail out a big hedge fund that went bust, Long Term Capital Management. And even though Greenspan had expressed worry that "irrational exuberance" was creating a stock market bubble, big losses by banks in currency speculation in East Asia and Russia led Greenspan to keep cutting rates, despite his foreboding that cheaper money would just pump up markets and invite more speculation.
So the Wall Street wiseguys have a very nice game going. When things are booming, they warn government not to spoil the party. But in a bust, they can count on the Fed to rescue them with emergency infusions of cash and cheaper interest rates.
The point is not that the Fed should let the whole economy collapse in order to teach speculators a lesson. The Fed also needs to remember its other role -- as regulator. (Editors' Note: Kuttner examines the Fed's role as regulator in detail in "The Bubble Economy" which appeared in the October issue of The American Prospect.)
Greenspan, however, disdained regulation, insisting that derivatives required no government intervention. The jury is still out on Bernanke. He testified Thursday that the mortgage sector needed stronger guidelines, but backed away from embracing more regulation generally.
The Fed's record on this front is terrible. Congress, anticipating mortgage problems, passed legislation back in 1994, requiring the Fed to regulate loan standards for all mortgage creditors, including the otherwise unregulated companies that brought us the subprime crisis. Yet for 13 years, the Fed stonewalled. Not until July, when the crisis was full blown, did the Fed reluctantly promise regulations by year-end.
The subprime explosion is a simple case of regulatory failure. There is little monitoring of the mortgage companies that originated the bait-and-switch loans, the investment companies that turned them into bonds, the private rating agencies that gave the bonds overly optimistic ratings, and the hedge funds that bought them.
And subprime loans occupy just one slice of the risky plays now endemic on Wall Street. Yet commercial banks, the regulated cornerstone of our monetary system, finance all these transactions, putting bank balance sheets and the whole economy at risk.
Commentators mistakenly debate whether Bernanke cut rates too much or not enough. That one-dimensional argument misses the point. We surely need lower rates to get through the immediate crunch, but it's not smart to bail out speculators with cheap money unless the Fed also acts as regulator to prevent the next crisis.
This piece originally appeared in the Boston Globe.
