federal-reserve-seal.thumbnail.pngThe oddest thing happened on the way to not nationalizing the banks, the Federal government started to do their jobs. That’s what the announcement that the Fed would start buying and selling short term commercial paper meant. That’s what all the extended credit facilities mean. The Fed is lending to everyone the banks won’t lend to, and if it goes on, that could mean that the Fed winds up doing most of the lending itself. Sure, it’s not actually lending to individuals directly, but it’s financing American business directly at this point, will probably be financing all the States if this goes on, and so on.

The fundamental problem is that the Fed wants money loaned at below the rate of inflation, far below it, and the banks don’t want to do that. The normal response to this problem would be to raise interest rates, which tells banks they can raise theirs and which also squashes inflation. But if the Fed were to raise interest rates right now it’d crash the housing market even further, causing a huge wave of foreclosures as variable rate mortgages reset. That wouldn’t just make banks even more sickly, it’d hurt Fannie and Freddie, which the government is on the hook for.

This is the essential dilemma the central bank is in. Standard macroeconomic policy solutions don’t work any more. You can’t do what Volcker did, and just raise interest rates through the roof to drive inflation through the floor, to allow banks to lend at high rates and to generally wring the excesses out of the system. But lowering interest rates does no good because banks don’t want to lend that low, long term lenders refuse to lend that low (the Fed has lost complete control over long term interest rates) and businesses don’t want to borrow unless they absolutely must because they know they’re going into a recession? Who cares if you can borrow short term money cheap? What would you do with it? And long term money is expensive, not that most companies want to borrow long right now either (though in a bit the more forward looking ones would want to, to pick up bargains cheap.)

The time for a recession was 2005. At that time simple macroeconomic policy; simply raising interest rates, would have ended the bubbles in credit and housing at the cost of a standard if somewhat nasty recession. Trillions of dollars of intervention would not have been needed. Just standard macro policy. Even in 2006 it might still have worked. The Fed blew it, and they broke the system, and now with the system broken they may have to either buy it all out (and Paulson may be considering that after all) or just become the system. And even if they do that may not work, because, well, who wants to borrow and invest right now?

Bernanke and Greenspan are certainly in the "worst Fed chairman of all time" stakes in a big, big way.

Ian Welsh

Ian Welsh

Ian Welsh was the Managing Editor of FireDogLake and the Agonist. His work has also appeared at Huffington Post, Alternet, and Truthout, as well as the now defunct Blogging of the President (BOPNews). In Canada his work has appeared in Pogge.ca and BlogsCanada. He is also a social media strategy consultant and currently lives in Toronto.

His homeblog is at http://www.ianwelsh.net/