[OPE] Paul Krugman, Betting the Bank

From: glevy@pratt.edu
Date: Tue Mar 18 2008 - 08:52:34 EDT

SPIEGEL ONLINE - Druckversion - Paul Krugman: Betting the Bank -


03/14/2008 10:42
Betting the Bank 
Monetary policy can have
magical effects; but sometimes the magic doesn‚€™t work.
And this is one of those times. 

Bernanke, chairman of the board of the US Federal Reserve bank 
years ago, an academic economist named Ben Bernanke co-authored a
technical paper that could have been titled ‚€œThings the
Federal Reserve Might Try if It‚€™s
Desperate‚€Ě -- although that may not have been obvious from
its actual title, ‚€œMonetary Policy Alternatives at the
Zero Bound: An Empirical Investigation.‚€Ě 

the Fed is indeed desperate, and Mr. Bernanke, as its chairman, is putting
some of the paper‚€™s suggestions into effect.
Unfortunately, however, the Bernanke Fed‚€™s actions --
even though they‚€™re unprecedented in their scope --
probably won‚€™t be enough to halt the
economy‚€™s downward spiral. 

And if
I‚€™m right about that, there‚€™s
another implication: the ugly economics of the financial crisis will soon
create some ugly politics, too. 

To understand
what‚€™s going on, you have to know a bit about how
monetary policy usually operates. 

The Fed‚€™s
economic power rests on the fact that it‚€™s the only
institution with the right to add to the ‚€œmonetary
base‚€Ě: pieces of green paper bearing portraits of dead
presidents, plus deposits that private banks hold at the Fed and can
convert into green paper at will. 

When the Fed is worried
about the state of the economy, it basically responds by printing more of
that green paper, and using it to buy bonds from banks. The banks then use
the green paper to make more loans, which causes businesses and households
to spend more, and the economy expands. 

This process can be
almost magical in its effects: a committee in Washington gives some
technical instructions to a trading desk in New York, and just like that,
the economy creates millions of jobs. 

But sometimes the magic
doesn‚€™t work. And this is one of those times. 

These days, it‚€™s rare to get through a week without
hearing about another financial disaster. Some of this is unavoidable:
there‚€™s nothing Mr. Bernanke can or should do to
prevent people who bet on ever-rising house prices from losing money. But
the Fed is trying to contain the damage from the collapse of the housing
bubble, keeping it from causing a deep recession or wrecking financial
markets that had nothing to do with housing. 

So Mr. Bernanke
and his colleagues have been doing the usual thing: printing up green
paper and using it to buy bonds. Unfortunately, the policy
isn‚€™t having much effect on the things that matter.
Interest rates on government bonds are down -- but financial chaos has
made banks unwilling to take risks, and it‚€™s getting
harder, not easier, for businesses to borrow money. 

As a
result, the Fed‚€™s attempt to avert a recession has
almost certainly failed. And each new piece of economic data -- like the
news that retail sales fell last month -- adds to fears that the recession
will be both deep and long. 

So now the Fed is following one of
the options suggested in that 2004 paper, which was about things to do
when conventional monetary policy isn‚€™t getting any
traction. Instead of following its usual practice of buying only safe US
government debt, the Fed announced this week that it would put $400
billion (‚‚¨257 billion) -- almost half its available
funds -- into other stuff, including bonds backed by, yes, home mortgages.
The hope is that this will stabilize markets and end the panic. 

Officially, the Fed won‚€™t be buying mortgage-backed
securities outright: it‚€™s only accepting them as
collateral in return for loans. But it‚€™s definitely
taking on some mortgage risk. Is this, to some extent, a bailout for
banks? Yes. 

Still, that‚€™s not what has me
worried. I‚€™m more concerned that despite the
extraordinary scale of Mr. Bernanke‚€™s action -- to my
knowledge, no advanced-country‚€™s central bank has ever
exposed itself to this much market risk -- the Fed still
won‚€™t manage to get a grip on the economy. You see,
$400 billion sounds like a lot, but it‚€™s still small
compared with the problem. 

Indeed, early returns from the
credit markets have been disappointing. Indicators of financial stress
like the ‚€œTED spread‚€Ě
(don‚€™t ask) are a little better than they were before
the Fed‚€™s announcement -- but not much, and things have
by no means returned to normal. 

What if this initiative fails?
I‚€™m sure that Mr. Bernanke and his colleagues are
frantically considering other actions that they can take, but
there‚€™s only so much the Fed -- whose resources are
limited, and whose mandate doesn‚€™t extend to rescuing
the whole financial system -- can do when faced with what looks
increasingly like one of history‚€™s great financial

The next steps will be up to the politicians. 

I used to think that the major issues facing the next president
would be how to get out of Iraq and what to do about health care. At this
point, however, I suspect that the biggest problem for the next
administration will be figuring out which parts of the financial system to
bail out, how to pay the cleanup bills and how to explain what
it‚€™s doing to an angry public. 

a.. http://www.spiegel.de/international/0,1518,541438,00.html

a.. Bob Herbert: Sharing the
Economic Pain (03/13/2008) 
b.. Paul
Krugman: The Anxiety Election (03/07/2008) 

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