The Fed's Revolution

From BusinessWeek, The Financial Crisis March 20, 2008, 5:00PM EST

To head off a catastrophe, Bernanke has reinvented the central bank while injecting a huge dose of money into the system. - by Michael Mandel and Peter Coy

The current financial crisis—perhaps the biggest since the Great Depression—has turned Federal Reserve Chairman Ben Bernanke into a reluctant revolutionary. The quiet academic who wanted to make the post of Fed chairman less heroic is leading a dramatic expansion of the central bank's role. In the process, he is setting the stage for the next big boom—or bubble.

In the short run, Bernanke is waging a war to keep the financial markets from collapsing. The biggest move so far: On Sunday, Mar. 16, the Fed brokered the fire sale of troubled investment bank Bear Stearns (BSC) to JPMorgan Chase (JPM) and announced that it would be willing to lend directly to major Wall Street brokers, which have never before had access to loans from the central bank.

The two moves represented a new level of direct Fed involvement in the financial markets and made it clear that Bernanke would take any step needed to prevent a financial catastrophe. These maneuvers should work, says Julian Jessop, chief international economist of London-based research firm Capital Economics. ...

At the same time, by stepping in so aggressively, Bernanke is pouring an enormous slug of money into the financial system. To be sure, its full impact won't be felt right away, because banks are reluctant to lend and consumers are afraid to borrow. ...

Eventually, ... the Fed's stimulus will show up as some combination of stronger economic growth and higher asset prices. It also could boost inflation, further eroding the value of the dollar and raising the risk of a run on the world's most important currency. The possibility that a primarily domestic crisis could quickly become global highlights the need for international cooperation. Former Fed Chairman Paul A. Volcker, who broke the back of high inflation in the early 1980s, told BusinessWeek on Mar. 19: "If you have a closely integrated world economy with free trade and free movements of capital, the logical complement of that is a global currency."

The engine that eventually pulls the U.S. out of recession will most likely not be consumption but corporate investment. That will be good for big global corporations with clean balance sheets and access to markets around the world. The very fact that they already have plenty of cash will likely make investors all the more eager to fuel their expansion.

... The Fed-fueled boom of the 1990s was a big plus for the economy, because it stimulated investments in cutting-edge technology, which paid off as higher productivity and growth. That of the 2000s, though, mainly spurred homebuilding and higher house prices, with little or no long-term boost to growth. ...

GREENSPAN'S LEAD

Not everyone is pleased with Bernanke's approach. "They have basically polluted the world with dollars," says Dan North, U.S. chief economist for Euler Hermes, a unit of Allianz Group (AZ) that insures accounts receivables. "It lays the foundation for inflation and another asset bubble later on."

... Bernanke is going further than Greenspan ever did in responding to a popping bubble. He has pulled out all the stops, inventing new ways to pump money into a resistant financial system. For example, the Primary Dealer Credit Facility that the Fed announced on Mar. 16 could lend hundreds of billions of dollars to brokers such as Lehman Brothers (LEH), protecting them against the sort of panic that brought down Bear Stearns.

One measure of the size of monetary stimulus is the expansion of M3, a broad measure of the money supply that includes institutional money funds. Capital Economics calculates that M3 is up 15% from a year ago, the biggest increase in 37 years.

... The 2001 recession officially ended in November of that year, but Greenspan had to keep reducing interest rates for two more years to avoid deflation, a dangerous downward spiral of prices. His final cut to 1% came in June, 2003, and Greenspan didn't start raising rates until 2004.

STUCK IN LOW GEAR

Bernanke will have to be equally deliberate in taking back the money he has lent. He can't relax the monetary stimulus until George W. Bush—or his successor—steps in with a plan to lessen the burden of the bad mortgage debt. That could mean forcing lenders to reduce mortgages that far exceed the value of homes or some program to get bad loans off the books of financial institutions and investors. "The Fed can keep the financial system afloat," says Barry Eichengreen, an economist at University of California at Berkeley. "And it will have to do that until the Treasury and the Congress figure out an effective and politically acceptable way of injecting capital into the banking system."

... The big question: deciding how to allocate the giant losses among homeowners, investors, or taxpayers.

... It could take three to four years for Americans to work their debt down, unless the government steps in to help.

Part of the problem is that many lenders that financed the debt are disappearing as independent companies. Countrywide Financial (CFC), which is slated to be acquired by Bank of America (BAC), by itself made an astounding $2 trillion in home loans between 2000 and 2006.

BIG WILD CARD

On the other hand, much of the nonfinancial corporate sector is in good shape. So lending to businesses—even startups—is likely to be strong. Venture capital funds raised almost $35 billion in 2007, the highest level since the tech boom. ...

The biggest wild card right now is the dollar. Over the past year, its value against the currencies of U.S. trading partners has dropped by 10%. That has stimulated exports, which climbed in volume by 8% over the past year, and held down the volume of imports, which rose just 2%.
But if the dollar slips too far and too fast, global investors will see the value of their investments in the U.S. plummet.

... (The Fed's) weapon for fighting financial collapse is printing money. But the more dollars it prints, the faster the dollar will fall.

... Capital Economics' Jessop notes that two of the strongest currencies are in countries whose central banks have kept rates low: Japan and Switzerland. In the end, the U.S. may require an unprecedented amount of cooperation from global central banks to keep things afloat. That could mean coordinated interest rate cuts. Says Berkeley's Eichengreen: "The Europeans have been underestimating the impact that events in the U.S. will have on their economy."

Will the booms and busts ever level out? Probably not. It's the nature of modern financial systems to push the next big thing as far as it will reasonably go. And sometimes beyond.

[TJ: It is almost a certainty that the Fed will begin to raise interest rates after this November's elections or at some time in early 2009 to defend the value of the USD and to appease the world's other central bankers. When rates rise, real estate prices rise...it's a natural response. Buyers/investors want to lock-in the low rates, and so there is a flurry of buying activity, which results in rising prices for real estate.]