With Wall Street beset by a crisis of confidence and the mortgage-backed securities market seizing up, there is urgent need for an immediate emergency Federal Reserve interest rate cut. This sudden need has also revealed how today’s financial system places monetary policy in bondage to markets. That system has evolved over the past twenty-five years with the Fed’s approval, and the current crisis starkly reveals need for reform.
An emergency rate cut is needed to prevent the sub-prime mortgage meltdown from spiraling into a full-blown recession. By immediately lowering the base cost of credit, a rate cut can make existing mortgage securities more attractive to investors and also encourage continued flows of mortgage finance for the housing market.
Such continued financing is critical. In its absence mortgage availability will shrink and mortgage rates rise, thereby deepening the housing market slump. That is likely to trigger additional mortgage defaults and reductions in construction activity, thereby perhaps even causing a recession. In this event, the spiral of credit deterioration stands to deepen, jumping from the sub-prime mortgage market to the entire housing sector and the economy more broadly.
In response to this threat the Fed has already moved to inject significant temporary additional liquidity into money markets, effectively lending billions of dollars to banks to prevent their having to make further asset sales under current distressed conditions. Central banks in Europe, Japan, and elsewhere have done the same. However, because the costs of recession promise to be so large, the Fed must also move to cut rates.
As recently as ten days ago Fed policy was focused on containing inflation. Now, within the blink of an eye, the evaporation of confidence among Wall Street lenders has created conditions warranting an emergency rate cut to save the economy. This power of financial markets is rooted in a new business cycle that emerged in the 1980s and which has made the economy increasingly dependent on debt to fuel expansions. The creation of debt in turn relies on highly leveraged financial intermediaries that package and re-package loans while promising liquidity they are unable to deliver. As a result, the system has become fragile.
Increased financial fragility is one feature of the new system. A second and worse feature is that increased debt is part of a complex for shifting value from the real sector to the financial sector – a phenomenon known as “financializationâ€. This increases profits in the financial sector at the expense of the real economy. Meanwhile, the new structure also implicitly compels monetary policy to rescue the financial sector if it gets into trouble. This amounts to a policy stick-up whereby the Fed is forced to provide the get away car for fear that not doing so will result in even greater economic damage.
Today’s system places monetary policy in a double bind. In good times the Fed is forced to raise interest rates to maintain lender beliefs that inflation will remain low. Those beliefs ensure investors are willing to make the loans needed to fuel the system. However, the result is higher interest rates and curtailed expansions that hold down wages and employment, thereby limiting the share of productivity growth going to working families.
In bad times, such as we are now experiencing, the Fed is obliged to come to the rescue of lenders for fear that if they stop lending the economy will tank. Moreover, this fear deepens the greater the level and burden of debts. Worse yet, such intervention creates a problem known as “moral hazard†that can aggravate the need for rescues. Having the Fed intervene to prevent financial meltdowns tacitly puts a floor under financial markets. That floor acts as a form of insurance for investors and speculators, who knowing that they are protected against large losses then channel more funds into even higher risk investments and loans.
The Fed has actively promoted the new system through deregulation. Its claim has been the risks of the financial system imploding are less because risk is spread. That claim is now being shown to be false.
For two decades working families have felt the effects of the policy head-lock imposed by financial market demands for ultra-low inflation. Now, financial markets are exercising their other demand for interest rate cuts to preserve asset values in order to prevent recession.
The threat posed by the current crisis is such that the Fed should meet this demand. That means immediately cutting rates and continuing to judiciously provide emergency liquidity. However, once the storm passes Congress and the Fed must address the systemic problems and policy distortions that have been exposed by the current crisis.
Copyright Thomas I. Palley
What is needed is for American corporate sector to increase drastically the net fixed business capital investment, thereby increasing the stock of new plant and equipment and deploying advanced processes and technologies. Remember that continually robust levels of net fixed business capital investment is vital to future industrial development and military power.
The moral hazard is enormous. The constant bailouts cost the average person their financial stability. The bailouts have to stop and the only way to do that is to let it play out (IMO). We need the graphical images of road kill.
It was a presumed change in the business cycle starting in the 1980s that placed the finance sector in a position to leverage debt as a method of economic expansion, right?
What exactly seemed to be the set of de-regulating policies that STARTED this new business cycle in the 1980s?
Was the repeal of the Glass-Steagall Act in the 1990s the icing on the cake for
business de-regulation?
The over-reliance of corporate bail-outs by the Fed will probably aggravate and put pressure on federal spending for various other programs.
Has the Fed ever considered a discount rate with an added point to companies or sectors that have exhibited historical woes in bail-outs and bad accounting practices?
Whatever policies the DNC advocates for, corporate regulations must also coincide with promoting development as well but I could definitely see Repubs blaming Dems and Libs for a worsening economy in future elections.
Great article.
Great article. Wanted to ask the author about his theory of wealth transfer from the real to the financial sector: if inflation is stable is the wealth transfer or ‘financialization’ not somehow mitigated? Stable prices with increasing real incomes does imply a growth in physical productivity — no — and wouldn’t this be tantamount to a growth in the real economy?
[…] No wonder we have comments like this. From economist Thomas Palley: As recently as ten days ago Fed policy was focused on containing inflation. Now, within the blink of an eye, the evaporation of confidence among Wall Street lenders has created conditions warranting an emergency rate cut to save the economy. This power of financial markets is rooted in a new business cycle that emerged in the 1980s and which has made the economy increasingly dependent on debt to fuel expansions. The creation of debt in turn relies on highly leveraged financial intermediaries that package and re-package loans while promising liquidity they are unable to deliver. As a result, the system has become fragile. […]
I fear it’s already long too late and this meltdown has obviously been long in coming. You fairly clearly outline the double-bind the Fed is in, but your call for a rate cut will be of little avail. To cut the Fed rate, especially if sharply, would depreciate the dollar, raise inflation and thus raise long-term interest rates, (which, er, the Fed does not directly control), and thus prove self-stultifying. Ultimately, an economy based on stagnant wages and employment and increasing amounts of debt to sustain demand, (which only incentivizes financial profits over real productive capital investments and correspondingly encourages ever increasing amounts of leverage to facilitate financial profits), can’t be sustained and must come to an end. But to change in any fundamental way the monetary regime that leads to ever recurring bubbles and thus ever increasing financialization requires a painful shift in systemic incentives, (to say nothing of political organization), that no mere economic theory can engineer. Only dissolving the hold of leveraged finance upon the real economy could allow for the sort of re-alignment that is needed toward more genuinely sustainable and socially equitable real investment, which requires both liquidating accumulated mal-investment and sectoral and international imbalances, and only the pain of such processes will allow for a fundamental change of regime from without the illusion and self-complacency of a self-sufficient monetary policy. The best the Fed could do, -(and they’re not on “our” side anyway)-, is to retard the “great unwinding” to a degree sufficient for its more-or-less orderly market-wide management, without feeding further “moral hazard” into the system.
[…] First is the group that thinks that central banks should do whatever it takes to keep the markets afloat. The most extreme and vocal advocate is Jim Cramer, followed closely by Don Luskin, but they have some intellectually respectable company, such as economist Thomas Palley (albeit with caveats that would set Cramer off): In bad times, such as we are now experiencing, the Fed is obliged to come to the rescue of lenders for fear that if they stop lending the economy will tank…. […]
[…] followed closely by Don Luskin, but they have some intellectually respectable company, such as economist Thomas Palley (albeit with caveats that would set Cramer off): In bad times, such as we are now experiencing, the […]
[…] followed closely by Don Luskin, but they have some intellectually respectable company, such as economist Thomas Palley (albeit with caveats that would set Cramer off): In bad times, such as we are now experiencing, the […]