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The Fed Can't Do It Alone

By Alan S. Blinder
Tuesday, March 18, 2008

Psychology has now overwhelmed economics. What started last summer as a serious problem in a little-known -- but not so little -- corner of the U.S. mortgage market has blossomed into a worldwide financial panic, the sort we read about in history books. Except within the Republican Party, laissez-fairy tales have been discarded, and government support is being both sought and given.

The financial markets live or die on confidence. If you sell a security, you must believe the other guy will pay. You must also believe that something worth $30 at Friday's close, such as shares of Bear Stearns, will not be worth $2 at Monday's open. Such confidence looks to be draining from the system.

Who can restore it? Once upon a time, it was J.P. Morgan -- the man, not the company. Today, it must be the world's leading central banks and treasuries, starting with our own.

Unfortunately, this past weekend was a bad one for Team USA. On Friday, President Bush gave a speech at the Economic Club of New York that left people wondering whether he was in touch. On Sunday, Treasury Secretary Henry Paulson, who has been eerily silent as this crisis unfolded, made the rounds of the morning talk shows. It was not reassuring to see this former titan of Wall Street recite his talking points. Wolf Blitzer asked him five times, "Why did you bail out Bear Stearns?" He never got an answer.

Actually, the Treasury didn't bail out Bear Stearns; the Federal Reserve did. Chairman Ben Bernanke and the Fed have been working overtime; they have slashed interest rates and lent or offered money to almost everyone potentially involved in this mess. On Sunday, the Fed even put its own balance sheet at risk to smooth the way for J.P. Morgan (the company, not the man) to "buy" Bear Stearns. But the stunningly low purchase price, far below even the value of Bear Stearns's Manhattan building, did not exactly inspire confidence.

Earth to the White House and Congress: The Fed cannot do this job alone.

But isn't the central bank the fabled "lender of last resort"? Yes, and the Fed is performing that role extensively. But central banks are designed to lend money to banks that are illiquid but not insolvent. It is not supposed to spend taxpayer money or even put much of it at risk. Those political decisions are properly made by elected leaders.

So what can be done now?

First, everyone should take a deep breath. To those living far from the canyons of Manhattan, the sky is not falling. If you don't want to sell your home, forget about falling house prices. Even on paper, it's unlikely that you've "lost" anything near what you "gained" in the run-up. Yes, the economy is limping, but it's not collapsing. And the effects of the Fed's interest rate cuts and the stimulus package that Congress enacted last month are still to come.

Second, it would be nice to see some patient capital step up to the plate. With so many assets on fire sale, buying opportunities abound. Highly leveraged public companies with mark-to-market accounting and daily liquidity drains are too petrified to buy. But patient investors who don't need liquidity and don't have to worry about mark-to-market accounting have a chance to be the J.P. Morgans of our day.

Third, our nation's great financial houses need to use the breathing space the Fed is providing to put themselves in order -- post haste. They need to come clean, book the losses and, in many cases, raise new capital. If the capital must come from abroad, Americans must set aside their pride and/or xenophobia. (By the way, why are some of these companies still paying large dividends and enormous bonuses to their top executives?)

Fourth, we need leadership from political Washington. Forget the president. We need the Treasury secretary to take charge, not just to "support the Fed." While Paulson repeats his "strong dollar" mantra, confidence in the dollar ebbs. How about doing something about it -- such as a dramatic currency market intervention in concert with other nations?

Fifth, I'd like to hear the Fed, which has the credibility the administration lacks, talk more -- and in plain English. For example, I'd like to hear it answer Wolf Blitzer's question -- and others. I'm sure Bernanke can do it better than Paulson.

But our best hope for leadership from Washington may now be in Congress. Rep. Barney Frank (D-Mass.) and Sen. Chris Dodd (D-Conn.) are working on a fine bill that, by easing some of the stresses in the mortgage market, could do some real good. I urge Frank, Dodd and the Democratic leadership to expedite the process, and congressional Republicans should stop standing in the way.

In 1933, Franklin Roosevelt famously told Americans that "the only thing we have to fear is fear itself." Unbridled fear is gripping today's financial markets. We need some soothing words right now -- followed by actions, as FDR's words were. Who will step forward?

Alan S. Blinder, a vice chairman of the Federal Reserve from 1994 to 1996, is an economics professor at Princeton and vice chairman of the Promontory Interfinancial Network.

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