We're in one of those delicate times in economic policymaking when turmoil in credit markets demands a firm and steady hand -- one that balances the need to restore confidence without bailing out investors, bankers and fund managers who made a boatload of bad bets.
It's still early, but up to this point, the performance of the Bush administration and the Federal Reserve has been less than impressive. They were late to acknowledge the extent of the credit bubble and its potential impact on the economy. And ever since, they've been behind the curve, hamstrung by a free-market ideology and their own roles in allowing the bubble to develop in the first place.
The Fed was right yesterday to stand pat on interest rates rather than lower them. In the current market environment, a small move in the federal funds rate would have no real effect on the price of money. And it would have signaled to Wall Street that the Bernanke Fed, like the Greenspan Fed, was prepared to open the money spigot to put a floor under the market and prevent market turmoil from spilling over into the real economy.
At the same time, with its statement that it remains primarily concerned about inflation, the Fed missed a golden opportunity to signal that it takes seriously the risks of a credit crunch and a market-induced economic slowdown.
This has been a blind spot for the Fed, which always seems surprised when markets overshoot and invariably plays down the link between financial markets and the real economy until it is too late to do much about it. Now it has gone and done it again. For an organization that claims to be scanning the road for bumps and potholes up ahead, the Fed spends way too much time looking in the rearview mirror.
Equally surprising has been the administration's Katrina-like response to the meltdown in the mortgage market, which has spread well beyond sketchy subprime loans.
As it happens, the one part of the mortgage market that continues to function somewhat normally is the one where modest-size mortgages are insured and packaged by Fannie Mae and Freddie Mac. This is precisely why Fan and Fred were created, to provide liquidity to the mortgage markets when others fear to lend. So you would expect the Bush administration to work with them to expand their purchase of mortgages, and invite them temporarily into other areas, such as jumbo mortgages, where private markets are failing.
Unfortunately, that would require the Fed and the administration, after having spent six years demonizing Fan and Fred and trying to reduce their size and influence, to eat a heaping serving of political crow. They would have to admit they were wrong when they said private banks could be relied upon to set lending standards and provide a reliable source of mortgage financing, in good times and bad. And they would have to acknowledge that giving Fan and Fred access to the government's backing might, in some instances, actually reduce the chance of a financial market meltdown, rather than increase it, as they so often predicted.
For weeks now, Fan and Fred have been talking to their regulator, James B. Lockhart III, director of the Office of Federal Housing Enterprise Oversight, about getting permission to step up their activity. So far, no answer. But, hey, what's the rush? The big wave of foreclosures probably won't happen until next year. And, anyway, the president thinks "Locky" is doing a heck of a job.
Meanwhile, at hedge funds, insurance companies and the big Wall Street banks, masters of the universe are sweating bullets over what they are going to tell investors and regulators about all those assets on their balance sheets that, suddenly, nobody wants to buy. They include credit swaps and other fancy derivatives, along with loans to private-equity firms for corporate buyouts. In the coming months, they will be required to put a "fair market value" on those assets -- a process that allows a wide degree of discretion. Looking over their shoulders will be regulators from the Fed, the Treasury and the Securities and Exchange Commission.
This process of "marking to market" puts the regulators on the horns of a policy dilemma.
If they force the banks, hedge funds and insurers to assign conservative values to the assets based on recent distress sales in areas with few buyers, it could send the markets into a tailspin. Lenders would be forced to call in loans, rating agencies would downgrade hundreds of billions of dollars in loans and bonds, and hedge funds would have to sell their "good" assets to pay off the loans they used to buy the "bad" ones.
On the other hand, if regulators allow them to use computer models to assign more optimistic values to those assets, they could be accused of helping the banks, insurance companies and hedge funds to mislead investors about the risks of lending and investing.
You could come up with a variety of ways for dealing with the tradeoff between reducing risk to the financial system and encouraging transparency. My solution would be to allow some flexibility in valuation, which would help to calm markets, while requiring all of those financial institutions to set aside more money as a cushion for lenders and investors in case things turn sour.
But the larger point here is that, with the laudable exception of the Federal Reserve Bank of New York, the government remains shockingly ho-hum about a credit-market crisis that could and should have been anticipated months ago.
Nobody wants or expects the government to step in and bail out bankers and fund managers who got rich playing too fast and loose with other people's money.
But when, as result of market and regulatory failures, millions of Americans face the prospect of losing their homes, jobs or retirement savings, you'd expect the government to show a bit more urgency and candor about the problem, and more creativity and leadership in addressing it. This is hardly the time to head for the ranch and the beach and leave everything to Mr. Market.