Why the Fed Can’t Restore Confidence and Who Can

I wish I had good news to write about the economy. I wish I could give you some theory that would support the widespread belief that the Fed is able to manage the economy and the stock market. I can’t.

Many naively believe that the Fed has done a good job in managing the economy. Many have little understanding that the economy is made up of the uncontrolled daily interactions among millions of consumers and firms. The economy is not under the control of the Fed, or of Congress, or of the President.

Martin Fridson provides a good metaphorical image of our economy: “A useful image of the U.S. economy account is a boulder rolling down a hill, flattening everything that stands in its path. The President, Congress and the Federal Reserve run alongside the bolder, vainly trying to nudge it this way or that—often pushing in opposing directions. For the most part, the boulder will probably determine its own course.”

Among the general public, there is little appreciation that the economy is not controllable in a meaningful way. “They” should do something about it—that is the rallying cry of many when problems arise. Exactly who “they” are varies depending upon the political view of those advocating the intervention. The belief in the omnipotent “they” is so strong that when things inevitability go wrong, the cry in the crowd is to get a new “they.”

The financial press is full of headlines such as this one in the normally free-market Wall Street Journal: “Fed’s Tricky Task: Avoid Recession Without Rewarding Excesses.” There are so many faulty premises implicit in that headline, that it is hard to know where to begin.

First, we have the implicit belief that the Fed can help manage the economy. Because a belief is widespread does not make it true. There was once a widespread belief in the curative, medicinal powers of bloodletting.

Next, we have the premise that the Fed can intervene without rewarding excesses. How could that be true? Bailouts stop the market process from punishing those who take imprudent financial risks.

The current mess is not just a product of cheap credit provided by the Fed. It is also a direct result of Wall Street’s irresponsible bundling of home loans. The theory was that by bundling the loans, the buyers of the loan bundles would not have to pay any attention to risk.

Of course since the lenders were selling off loans, they had no incentive to pay any attention to the real financial condition of the borrowers to whom they were lending. The belief was that any problems with substandard loans would even out in the wash when they were later repackaged.

As long as interest rates remained artificially low and housing prices kept steaming ahead, the problems were buried. Those who called attention to these issues were dismissed by the public and media. The media gave near monopoly space and air-time to those who proclaimed Greenspan a great “maestro” of the economic expansion and those who predicted that housing prices could go to the moon.

As a housing boom continued, economic illiteracy spread to those who should have known better. Analysts saw people cashing out their home equity in record amounts and declared it was good for the economy. They reasoned that this would further fuel consumer spending. Greenspan even encouraged the use of adjustable-rate mortgages. Many homeowners took his advice by trading in their fixed-rate mortgages for the initial lower rate that adjustable-rate mortgages provided. The personal savings rate plummeted into negative territory but the consequences of the plunge were masked by this consumer spending.

Where does this leave us? Surely the Fed that provided the fuel for reckless behavior cannot solve the problem by providing fuel for more reckless behavior. Surely big institutions that recklessly bundled substandard loans should not be given immunity from their actions while the little guy loses his home. Actions such as those don’t restore confidence; they destroy confidence.

Many individuals and institutions have been addicted to cheap credit. The Fed has played the role of the pusher. The market’s rally last Friday on news of the Fed’s interest rate cut has no more long-term significance than an addict settling into a euphoric high after his latest fix.

Anyone who has ever lived with an addicted family member has experienced the pain and heartache that goes with deciding what to do. The addict will promise over and over again that, if they are bailed out just one more time, they will go straight. They appeal to family loyalty. They seem so believable; but yet in most cases, until they are allowed to hit bottom, there is no recovery.

If they check into a treatment center, the treatment center doesn’t give them a little bit of alcohol or cocaine to help tide them over. Yes, the addict affects the whole family in terrible ways; but bailing out the addict and allowing them to continue on with their reckless and destructive ways, only postpones and escalate the consequences.

There is one way out of our current mess that few speak of. In the panic of 1907, the stock market fell 50% from its 1906 peak. Panic was spreading and J.P. Morgan organized fellow bankers to issue lines of credit and buy stocks. The panic quickly passed.

Voluntary action by the big players that helped to create the mess, allows those who created the problem to bear the consequences. It demonstrates that they have confidence in the economy and that they are willing to clean up their own house. Out of that kind of intervention, there is the potential for healthy economic growth to follow. Out of more Fed intervention, only another crisis will follow.

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4 Responses to Why the Fed Can’t Restore Confidence and Who Can

  1. Jerry says:

    The Fed managed to create a credit bubble for sure. The middle class and the working class (of course!) are paying the cost of it (both in the form of inflation and in the inability to face the debt they incurred during the past few years).
    Of course, during the 2004 campaign politicians were able to show an “improved economy” but now we are starting to see the consequences.

  2. Really good commentary

    “Where does this leave us? Surely the Fed that provided the fuel for reckless behavior cannot solve the problem by providing fuel for more reckless behavior. Surely big institutions that recklessly bundled substandard loans should not be given im…

  3. […] Why the Fed Can’t Restore Confidence and Who Can I wish I had good news to write about the economy. I wish I could give you some theory that would support the […] […]

  4. Update: Yesterday Bank of America made a $2 billion investment in failing Countrywide Financial Corp. This is the type of voluntary action by the affected players that can help to restore confidence.

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