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The Fed's Revolution


To head off a catastrophe, Bernanke has reinvented the central bank while injecting a huge dose of money into the system

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 end of the day, the Fed can provide a lot of support," he says. "It certainly won't prevent a sharp downturn, but it should prevent a debt deflation spiral."

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. Indeed, consumer spending is likely to lag, leading to job cuts in coming months and a deepening of the recession.

Eventually, though, 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.

Still, the jury is out on whether the Fed's actions will result mainly in a useful boom or a wasteful bubble. 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. Except for the best-educated workers, many saw real wages fall.

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."

In some ways, Bernanke is following the lead of former Fed Chairman Alan Greenspan, who argued that the central bank should not try to pop bubbles beforehand. Instead, the appropriate role of the Fed is to cushion the impact when the boom comes to an end. In a Mar. 17 article in the Financial Times, Greenspan said: "Periods of euphoria are very difficult to suppress as they build [and] they will not collapse until the speculative fever breaks on its own."

But 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.

Having embarked on this course, Bernanke has no way to head off the next boom-bust cycle. When you are taking antibiotics, the doctors warn you to take the full dosage to keep the germs from coming back more virulent than before. In monetary policy, too, the full course of treatment—more rate cuts—is essential. 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 process of putting together a rescue program is not going to be quick. The big question: deciding how to allocate the giant losses among homeowners, investors, or taxpayers.

Until that happens, consumer spending is going to be stuck in low gear. The problem is that American households took on extraordinary amounts of debt since 2000. By BusinessWeek's calculation, they owe about $3 trillion more than they would have if they had stayed on the long-term trend of the 1990s. That's a big number, even in today's economy. 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. As financing dries up, even consumers who want to borrow are facing reluctant lenders. J. Patrick Lashinsky, CEO and president of ZIP Realty, an online discount broker, cites a recent example of a homebuyer who had been preapproved for a 3% down payment. Right before closing, he was told the down payment would have to be 5% and the interest rate half a percentage point higher, causing the deal to fall through.

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.

Still, some businesses have much the same problem as consumers. "We have variable-interest rates on bonds that are adding a lot to our cost of doing business and adding absolutely no value to care," says Paul Levy, an economist by training and CEO of Beth Israel Deaconess Medical Center in Boston. "That means we have less money available for capital investment."

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. That will push them to pull their money out, making the greenback drop even more. Under these circumstances, the Fed cannot protect the dollar. Its weapon for fighting financial collapse is printing money. But the more dollars it prints, the faster the dollar will fall.

Of course, many economists don't anticipate a dollar crisis. 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.

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