Mr. Bernanke's Bet

Tuesday, March 18, 2008

BEFORE HE was chairman of the Federal Reserve Board, Ben S. Bernanke was a Princeton economist who studied the influence of financial markets on the business cycle. Mr. Bernanke tried to show how and why ample bank liquidity and strong consumer net worth magnify growth in the "real" economy -- and how, on the other hand, bank failures and falling asset prices intensify recessions. According to Mr. Bernanke, this "financial accelerator" helped explain why the Great Depression was so long and deep. Now, at a moment when house prices are falling, credit is contracting and once rock-solid Wall Street firms are trembling, the Fed chairman appears to be following his own teaching.

Over the weekend, Mr. Bernanke took unprecedented steps to prevent a financial market correction from becoming a panic -- and turning a pending recession into something much worse. With 85-year-old Bear Stearns unable to meet its clients' demands for cash, the Fed facilitated the firm's takeover, at the fire-sale price of $2 a share, by the much stronger J.P. Morgan Chase -- in part by chipping in $30 billion for Bear's unmarketable mortgage-backed securities. Also, the Fed announced that it would, for the first time, allow top Wall Street investment firms to borrow low-cost short-term funds that had previously been available only to banks. This reflected the new reality of a financial system whose lifeblood is no longer just commercial bank lending but securitized debts of all kinds.

These steps came on top of the Fed's recent sharp interest rate cuts and its offer to let banks post troubled mortgage-backed bonds as collateral for up to $200 billion in Treasury bills. More rate cuts are likely to follow. In simple terms, Mr. Bernanke is pouring cash on the financial system as a mechanic would dump oil on rusty gears. The thinking, apparently, is that the credit pullback reflects an overreaction to the U.S. housing crisis that is no less irrational than the exuberance that drove investors to accumulate so many questionable mortgage-backed assets in the first place. Keeping banks and investment firms open, and markets functioning more or less normally, should buy time for a calmer, more accurate assessment of asset values, the accumulation of new capital by financial institutions and, ultimately, a softer landing for the economy.

There are risks in the Fed's approach. It is possible that Mr. Bernanke's drastic steps will communicate desperation rather than, as intended, confidence to financial markets. His policy could exacerbate inflation, which is already above the Fed's target range; and it will further weaken the dollar, which is trading at an all-time low against the euro. Though it also drives up oil prices, the weaker dollar otherwise improves the U.S. trade balance -- and, though U.S. officials don't like to say so publicly, it inflates away U.S. debts to foreigners. It is not clear, though, how much longer investors in the rest of the world will let the Fed continue to play this game.

Mr. Bernanke is well aware of these downsides. But faced with no good options -- only bad and worse -- he decided, with the Bush administration's support, to assume the risks. The hope is that he has correctly assessed the situation and that the Fed does succeed in averting financial catastrophe or spiraling inflation. If not, his actions could make a gloomy case study for some future professor of the dismal science.

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