Jan. 30 (Bloomberg) -- What’s the endgame?

Even as the U.S. economy sputters, the banking system teeters, the budget deficit heads for the stratosphere and the hand of government extends into all corners of the private sector, the public wants to know the way out.

This isn’t a theoretical question. We’ve been there, done that.

From the Great Depression to the 1970s, a huge chunk of the U.S. economy was “run through a series of government administered cartels,” says Neal Soss, chief economist at Credit Suisse. Airlines, telecommunications and banking were all highly regulated. The adverse effects of the government’s heavy hand took decades to manifest themselves, he says.

Now, with the government involved in the housing, auto and financial services industries (although in a different way than before), with small businesses and consumers in line for help next month via a new Federal Reserve lending facility, and with almost everyone looking to cash in on the action, Soss sees no quick exit from the “quasi-nationalized economy.”

For starters, the federal government has never been very good at slimming down. Growing at a slower pace is about the best it can do.

This time around, in addition to the trillions being thrown around by the U.S. Treasury and Congress, the Fed has gotten involved in a number of “new ventures,” invoking a provision of the Federal Reserve Act to extend credit to non-banks “in unusual and exigent circumstances.”

Double Duty

The concerns about the Fed’s exit strategy are twofold: the first is shrinking its bloated balance sheet in a timely fashion; the second is extricating itself from its broadened lending role.

“The Fed traditionally was lender of last resort to the banking system,” says Bill Poole, former president of the St. Louis Fed and a Bloomberg News contributor. “It was never envisioned as a lender to specific sectors. Traditionally that has all been done through Congress, subject to budgetary and political discipline,” to the extent they exist.

The Fed’s role when it comes to monetary policy is clearly defined, if not always well executed, by the 1951 Treasury- Federal Reserve Accord. That agreement restored the Fed’s independence after a period in which the central bank pegged short- and long-term Treasury rates to help the government’s war effort. Monetary policy reverted to its role as an agent of macroeconomic stabilization, not a tool to monetize the government’s debt.

Size vs. Composition

The Fed’s credit policy is a different matter.

“The Fed needs to establish the boundaries on the credit- policy side between itself and the government,” says Marvin Goodfriend, a professor of economics at Carnegie Mellon’s Tepper School of Business in Pittsburgh and former research director at the Richmond Fed.

Monetary policy concerns itself with the size of the Fed’s balance sheet. It matters very little for these purposes what the Fed buys to create high-powered money, or currency and bank reserves.

Credit policy has to do with the composition of the balance sheet: the type of assets the Fed buys.

“Liquidity assistance is a credit policy,” Goodfriend says. “No accord protects the Fed’s credit policies from misuse the way the 1951 Accord protects monetary policy.”

Ad-Hoc Confusion

Of course, Goodfriend wrote that in 1994. The paper was reprinted by the Richmond Fed in 2001 on the 50th anniversary of the Treasury-Federal Reserve Accord and is even more relevant today. The lack of any guiding principles on credit policy forced the Treasury and Fed to act in an ad-hoc fashion last year in deciding which institutions to save and what type of assets to buy. The actions created confusion and undermined confidence, Goodfriend says.

An agreement on credit policy wouldn’t tie the Fed’s hands when it comes to emergencies, such as the weekend last March when Bear Stearns Cos. collapsed. Many of the current lending facilities were created with a lag.

For example, the Fed announced the creation of the Term Asset-Backed Securities Loan Facility (TALF) in November that won’t be operational until next month. The $200 billion facility will increase credit availability to consumers and small businesses.

Off-Budget Spending

Poole says there’s very little difference between what the Fed is doing and what the federal government does in “providing loans through the Small Business Administration or Export-Import Banks.” These types of loans, directed at specific sectors of the economy, “need to be authorized through the federal budget process and financed by securities sales and tax revenue, not by printing money,” he says.

The Fed has expanded its balance sheet with assets no one wants. Short-term loans to companies (commercial paper) and banks can be rolled off quickly and easily. Not so with the $500 billion of mortgage-backed securities the Fed is buying and holding to maturity, Poole says.

It will be difficult enough for the Fed to contract its balance sheet in a timely fashion to head off future inflation. A bigger challenge will be unwinding the credit extended to various sectors of the economy because its actions “create a lot of vested interests,” Poole says. “Wouldn’t (House Financial Services Committee Chairman) Barney Frank be happy to see the Fed permanently involved in the housing market?”

As with most things, an ounce of prevention is the best cure. If the Fed had listened to Goodfriend back in 1994, investors might not be confused over the Fed’s credit policy today.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: January 30, 2009 00:01 EST