Government policy, said President Bush in a speech on March 14, is like a person trying to drive a car on a rough patch. If you ever get stuck in a situation like that, you know full well its important not to overcorrectbecause when you overcorrect you end up in the ditch.
Under Chairman Ben Bernanke, the Federal Reserve is recklessly steering the economy off the road.
Two days before the President warned of the dangers of overcorrection, the Fed announced that it would pour as much as $200 billion into U.S. banks in an attempt to soothe the jittery nerves of lenders pounded by a meltdown in the market for mortgage-backed securities. The Dow Jones Industrial Average soared after the Feds announcement, nearly recovering in one session the 500 points it had lost over the past three trading days.
News then leaked that one of Americas oldest brokerage houses, Bear Stearns, was in serious financial trouble. The market immediately took a 195-point nosedive, led by a 47% freefall, to $30, in Bears share price. In an extraordinary series of conference calls, the Fed once again rode to the rescue by arranging a 28-day line of credit for Bear Stearns, using J. P. Morgan Chase as an intermediary. Before the ink was dry on that plan, J. P. Morgan acquired Bear Stearns at the fire-sale price of $236.2 million ($2 per share), after the Fed promised to fund up to $30 billion of Bears illiquid (read worthless) assets.
Although the pundits generally applauded the Feds prompt responses to crisis, ordinary Americans should be more circumspect. They are on the hook.
The $230 billion was anted up over the next few daysand Fed officials did not rule out the possibility of additional salvage operations later onby permitting banks and other financial institutions to borrow Treasury securities using risky and nowadays not-very-marketable mortgage-backed securities as collateral. The Fed and the U.S. Treasury (meaning you, the taxpayer) are cosigners on these loans and will be held responsible if they are not repaid.
When all is said and done, the Feds salvage operations represent a massive transfer of wealth from taxpaying Americans to the financial services industry in general, and to Bear Stearns in particular, who got into trouble on their own by lending money on generous terms to home-buyers who could not make their payments. Rather than letting the bankers renegotiate their nonperforming sub-prime mortgages and take their losses, the Fed elected to bail them out.
The Feds job is to promote price stability by soundly managing the nations money supply. The danger is that, in moving quickly to prop up lenders, it has taken its eye off the ball. Inflation is beginning to rear its ugly head, despite the Feds attempt to distract attention from rising prices by pointing to stability in core inflation. Consumers wallets know better. The fact of the matter is that the annual rate of inflation now stands at 4.9% when food and fuel are included in the Consumer Price Index. The erosion of Americans purchasing power is even more obvious in foreign exchange markets. Over the past year, the dollar has declined 14.3% against other major currencies, and is at a record low against the euro.
After careful study of the historical record, the late Nobel laureate Milton Friedman concluded that inflation is always and everywhere a monetary phenomenon. He could find no inflationary period at home or abroad that was not preceded by sustained money expansion such as now underway. (It takes 12 to 18 months for the full effects to materialize.)
Yet, as expected, at the Open Market Committee meeting on March 18, the Fed cut its target interest rate to 2.25% As a result, the inflationary pressures already evident in the economy strengthened. And they strengthen any time the Fed helps the Treasury out by monetizing part of the federal budget deficit, which set a record of $176.6 billion in February; the deficit on Leap Day alone amounted to $33.6 billion.
Intervening aggressively by accepting bad debt as collateral for loans from its discount windowthe first time it has ever done soand by cranking up the printing presses at the U.S. Mint, the Fed is making a bad economic situation worse. It helped get us into the present mess by inflating the housing bubble with easy money. Why does anyone look to the Fed to get us out?