The danger resides in not acting fast enough
Former chairman of the Council of Economic Advisers under Ronald Reagan, Harvard Professor, and current head of that great institution the NBER, economist Martin Feldstein spoke at the same Jackson Hole conference that featured Ben Bernanke on Friday. Bloomberg:
“The economy could suffer a very serious downturn,” Feldstein, president of the group that dates U.S. recessions, told a Fed conference in Jackson Hole, Wyoming. “A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome.” Feldstein made a case for lowering the overnight lending rate between banks to 4.25 percent from 5.25 percent to cushion the economy from the fallout of defaults on subprime mortgages. Chairman Ben S. Bernanke told the same gathering yesterday that the Fed will do what’s needed to stop this month’s credit-market rout from ending the six-year expansion.
Lowering interest rates may result in a “stronger economy with higher inflation than the Fed desires,” a situation that Feldstein described as the “lesser of two evils.” “If that happens, the Fed would have to engineer a longer period of slow growth to bring the inflation rate back to the desired level,” said Feldstein, 67, president of the National Bureau of Economic Research. Some investors speculated that Feldstein was a candidate for Fed chairman before Bernanke was picked to succeed Alan Greenspan…
Feldstein had said in an interview yesterday that there is a “significant risk” of a downturn and urged the Federal Reserve to cut borrowing costs.
The US economy is in the midst of a credit crunch of unknown severity, as evidenced by the seizing up of various debt markets, including the Commercial Paper market. The situation was initially provoked by one class of highly levered investments — the mortgage market — but has since spread to other categories of liabilities. This must be nipped in the bud, because credit crunches caused by under-reaction to problems with highly leveraged investments have been the source of the worst downturns in US history. This is not about bailing out the poor judgment or moral failings of some individuals. It is about preserving the operations of a credit driven US economy — credit ceases to function in conditions of panic, and when collateral ceases to have known values. In our judgment, Martin Feldstein is correct in his analysis.
There are a number of reasons that markets often have declines that proceed in several stages. When an asset or investment bubble bursts, it can’t easily be stitched together again. Sometimes it takes a while for the market to figure that out, and when that happens, steep declines, well beyond the initial sell-off, can occur. The Fed should not make the same mistake that it made in 2000 when the NASDAQ market crashed by over 75%; in that case, the Fed under-reacted and cut rates half a year too late. The risks in that situation were limited, because of the nature of that market. The risks are far greater when they involve a highly leveraged investment that 75 million Americans own, and there is a global derivatives industry with significant exposure to that asset category.