Saturday, May 3, 2008

Considering the Consequences

Here are couple of articles that speak to the consequences of the Fed's actions since the outbreak of the financial crisis. From The Economist we learn that one reason for the run up in commodity prices is that the Fed is exporting its loose monetary policy to the world:

Another reason to suspect that the Fed is more than a bit player is that American interest-rate decisions have a disproportionate effect on global monetary conditions. Some emerging economies still peg their currencies to the dollar; many others have been reluctant to let their exchange rates rise enough to make up for the dollar's decline. As a result, monetary conditions in many emerging markets remain too loose. This fuels domestic demand, pushing up pressure on prices, particularly of commodities. All of which suggests that the Fed's decisions are propagated widely through the dollar.

So here we have another observer effectively claiming the Fed is a monetary hegemon and consequently, its choices affect many nations. I am glad I am not alone on this point. Closer to home we learn the Fed is now facing the consequences of its decision to rescue Bear Sterns from bankruptcy. Bloomberg's Craig Torres tells us that
...Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is ``a potential crisis in the student-loan market'' requiring ``similar bold action,'' Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

Student loans are just the start. Former Fed officials and other Fed-watchers say that Bernanke's actions in saving Bear Stearns will expose the central bank to continuing pressure to use its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians. The Fed satisfied Dodd's request today, expanding the swaps to include securities backed by student debt.

``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Critics argue that the result will be to foster greater risk-taking among investors emboldened by the belief that the government will bail them out of bad decisions.
To be fair, though, the Fed believed the alternative to rescuing Bear Sterns was a systemic failure of the financial system. Fed officials understood problems like the above might arise, but were willing to risk them in order to avoid the greater costs of a financial meltdown. However, as Ken Rogoff notes in the same article,
They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.
So the Fed-bail-out genie is out of the bottle and investors have taken notice. As long as that genie stays out of the bottle there is no way to escape further regulation in financial markets as noted by Alan Blinder.

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