August 11, 2007
Market Swings Are First Crisis for Fed Chief
By LOUIS UCHITELLE
Should the Federal Reserve help bail out billionaire hedge fund managers and millionaire traders — the very people who bought the risky mortgages that led to the current market panic?
That, in essence, is the question swirling around Ben S. Bernanke as he confronts the first crisis of his 18 months as Fed chairman.
There are no shortages of opinions, and some are being shouted. Jim Cramer, known for his histrionics on the CNBC financial news channel, angrily called for Mr. Bernanke to lower interest rates, something the Fed has resisted doing.
A week ago, Mr. Cramer charged that the Fed was “asleep” and that the chairman “has no idea how bad it is out there” in the markets. A video clip of his remarks has been viewed more than one million times on YouTube.
Lower interest rates would help operators of hedge funds and other money managers because the housing market presumably would strengthen as mortgage rates fell. A revived mortgage market would give the hedge fund operators and other holders of the risky securities a chance to sell them, which they are having trouble doing now in the current nervous market.
But others see a bigger danger for the economy in acting on the pleas of Mr. Cramer and others on Wall Street. Cutting interest rates to help the hedge funds would tend to encourage a resurgence of the very risky mortgage lending that has caused the current turmoil, rekindling the crisis.
The issue is often referred to as “moral hazard,” meaning that the risk-takers who brought on this panic would feel bailed out and would be more likely do it again — just as a young adult whose parents paid off a large credit card bill might feel free to run up a debt again.
“The argument is people did risky things,” said Jan Hatzius, the chief domestic economist at Goldman Sachs. “They are getting punished now, and if you ease interest rates, you reduce the punishment.” Mr. Bernanke sees the issue in a more pragmatic way. The Fed’s actions and words suggest that, far from concerning himself with moral hazard, the Fed chairman is trying to protect, and thus reassure, ordinary investors in stocks and bonds.
By pumping a total of $62 billion on Thursday and yesterday into the pool of funds available for lending, the Fed can help enable small investors to continue to trade securities, confident that the checks they receive from their brokers will not bounce. This new liquidity allows the banks to provide credit to the marketplace without driving up interest rates.
Short-term rates, in fact, had spiked because of the panic, and the Fed’s action brought the key rate that it controls back to the 5.25 percent level that the Fed considers about right to keep the economy growing while minimizing the risk of higher inflation and, eventually, a slowing economy.
“The first line of defense for dealing with a liquidity problem is to make sure the system has enough reserves, so there can be an adequate amount of lending,” said Brian Sack, an economist at Macro Economic Advisers.
The next line of defense, if the market jitters were to persist and threaten a recession, would be to cut interest rates. Mr. Cramer and some others on Wall Street want Mr. Bernanke to do that now.
Mr. Bernanke has kept the so-called federal funds rate steady for more than a year, arguing as recently as this week that the economy is reasonably strong and that cutting interest rates might drive up inflation.
“The predominant policy concern remains the risk that inflation will fail to moderate as expected,” the Fed said in a statement after its last policy meeting, on Tuesday.
Still, if the panic persists and the economy begins to suffer, Mr. Bernanke would presumably be forced to rely on the only other tool the Fed has: a rate cut.
His training, and the books and scholarly papers he has written, suggest he would be reluctant to do that. In some circles, he has been called Helicopter Ben, because of a 2002 speech in which he suggested that if interest rates went to zero in a very weak economy, he would resort to showering money from helicopters into the financial system to keep it humming.
Some have cited the nickname in urging him to cut interest rates, which is a different issue than the one he was discussing in 2002. Indeed, his background suggests a different way of thinking, one in which market panics should be dealt with not by cutting interest rates but by focusing on short-term liquidity.
As a Princeton University economist, for example, he wrote extensively in the 1980s about the causes of the Great Depression. He produced two major books on the subject and he argued that the Fed could have prevented the damaging bank runs if it had provided the necessary liquidity, as he is trying to do now, thus calming depositors instead of forcing banks to turn them away empty-handed.
The Fed failed to do so in the 1930s, departing from tradition. For more than 150 years, Mr. Bernanke has noted, central banks have played the role of lender of last resort, providing enough liquidity to allow banks to operate normally, regardless of the pressures on them.
Some argue that if Mr. Bernanke is unwilling to cut the federal funds rate of 5.25 percent — the interest that banks pay to borrow from the marketplace — then the Fed should at least cut its discount rate.
This is the rate that the Fed charges to lend money directly to banks and other lending institutions, and it is now at 6.25 percent. Mr. Cramer, among others, has called for a discount rate cut, but Mr. Hatzius argues that such a cut might add to the gathering crisis.
Most traders, he notes, expect that by the end of the year, the Fed will have cut the federal funds rate by half a percentage point.
“If the Fed were to cut the discount rate,” Mr. Hatzius said, “then you would multiply the expectations of a much bigger cut in the federal funds rate, and that in itself could be damaging for the economy.”
For all the turmoil in the markets this past week, the number of people involved appears to be relatively small. They are mostly engaged in hedge funds, banks and mortgage lending and they are usually wealthy. Hedge funds, for example, require investors to have a net worth of at least $5 million.
“It is a limited crisis as of now,” said Albert M. Wojnilower, a Wall Street economist. “And if I had to bet my life, I would bet that it would remain that way. But I would not want to bet my life.”
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