The Flu and the Fed(s)

THE BE YOUR OWN ECONOMIST ® BLOG

There’s been so much bad news lately, how does one adequately describe the situation?

It feels like the economy has caught a bad case of the flu. The nose isn’t running like an open spigot (yet), but there’s a sniffle and feeling of chill and some aches and pains. You know that tomorrow will be horrible and there’s nothing you can do to prevent that turn of events. You’re about to spend a few days in bed.

The Fed(s), i.e. the federal government and the Federal Reserve have done what they believe to be prudent. Yet it has that “too little, too late” feel. As if we have a “two-bucket” fire but only one bucket of water. We throw the water on the flames and fetch another bucket. Too bad, because now we wave a three-bucket fire and only two buckets of water. And so it goes…….. Always a bucket short.

Why? Because the remedies are not adequately focused on the ailment. The Fed’s 2000/2001 easy-money policy is the root cause of today’s predicament. That policy stimulated a housing sector that was not in a slump and required no stimulation. The consequent residential-construction boom created an asset-inflation and a glut of homes. Now we are locked in an asset deflation that will not end until the market absorbs those excess homes. Moreover, the financial system remains polluted by the toxic waste, aka mortgage-backed securities, that financed and enabled the asset inflation.

Meanwhile, our fiscal-policy remedies are broad-based, not narrowly focused. The tax rebate will give consumption a boost, but will not reduce the glut of homes. The Fed is driving down the federal-funds rate and providing liquidity to the banks by exchanging Treasury securities for mortgage-backed securities, but it can’t compel reluctant lenders to advance funds to those they deem not credit-worthy.

There surely is a limit to what can be done. There is, after all, a glut of homes. The Fed can only push so hard on its string. But the federal government could sponsor a massive mortgage-purchase program that took the toxic-waste off lenders hands and stopped the foreclosures. It’s true that would validate moral hazard and entail more deficit-spending and federal borrowing. So what? Why moralize? Maybe the benefit is worth the cost. Isn’t that kind of directly-focused use of funds better than a broad-brush rebate?

Once again, there is no magic wand that can make the glut of homes go away. Wealth will be destroyed as home prices fall to equilibrium. But why fiddle as Rome burns? Let’s use all the buckets we have to douse as much flame as possible. Rome may end up scorched, but at least it will be standing.

© 2008 Michael B. Lehmann