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Jeff writes:
The roots of crisis | Comment is free: The US federal reserve's desperate attempts to keep America's economy from sinking... do not seem to be effective. Although interest rates have been slashed and the Fed has lavished liquidity on cash-strapped banks, the crisis is deepening.
To a large extent, the US crisis was actually made by the Fed.... [I]n 2001... the Fed turned on the monetary spigots to try to combat an economic slowdown... pumped money into the US economy and slashed its main interest rate.... The Fed held this rate too low for too long....
What was distinctive this time was that the new borrowing was concentrated in housing... commercial and investment banks created new financial mechanisms to expand housing credit to borrowers with little creditworthiness. The Fed declined to regulate these dubious practices....
[T]he home-lending boom... became self-reinforcing... buying pushed up housing prices, which made banks feel that it was safe to lend money to non-creditworthy borrowers.... [T]he Fed, under Greenspan's leadership, stood by as the credit boom gathered steam.... At a crucial moment in 2005... Bernanke described the housing boom as reflecting a prudent and well-regulated financial system, not a dangerous bubble. He argued that vast amounts of foreign capital flowed through US banks to the housing sector because international investors appreciated "the depth and sophistication of the country's financial markets (which among other things have allowed households easy access to housing wealth)."...
The housing bubble was bursting by last fall, and banks with large mortgage holdings started reporting huge losses, sometimes big enough to destroy the bank itself, as in the case of Bear Stearns.... [T]he Fed... has been cutting interest rates.... But... credit expansion is... flowing into... commodity speculation and foreign currency. The Fed's easy money policy is now stoking US inflation rather than a recovery....
Having stoked a boom, now the Fed can't prevent at least a short-term decline in the US economy, and maybe worse. If it pushes too hard on continued monetary expansion, it won't prevent a bust but instead could create stagflation - inflation and economic contraction...
I confess, I don't see why the Fed can't prevent a recession. Push the value of the dollar down far enough and export and import-competing manufacturing will grow fast enough to prevent a recession. The Fed may not like the inflation that this generates. But I don't see why monetary expansion will necessarily be ineffective in boosting output and employment.
