Will "Helicopter Ben" Bernanke Ride to the Rescue?

There’s growing sentiment on Wall Street that Federal Reserve Chairman Ben Bernanke will cut interest rates—if not now, certainly at the Fed’s scheduled September meeting—to stabilize the financial markets and keep the economy on strong footing. Mark Zandi, head of the Economy.com forecasting service, believes the Fed could cut rates pretty soon to avert a credit crunch, according to this Associated Press story. And the markets are betting on it: Fed Funds futures have priced in a quarter-point rate cut at the next meeting, and futures prices are starting to lean toward a half-point cut.

I wouldn’t bet on it. And based on what we know at this hour, I don’t think he should.

Sure, there’s a lot of carnage—jobs lost in the mortgage and housing sectors, lenders sitting on defaulted loans, investors nursing big losses. Three weeks ago, the informed speculation was that Bernanke might begin to set the table for a future rate cut: Conservative columnist Robert Novak just penned a column saying that Fed staffers had written a new statement, ready to approval, that would have changed the Fed’s bias from “neutral” to leaning toward a rate cut as its next move.

But now, Bernanke can’t—not and have any credibility left. For one, if he cuts rates and it doesn’t staunch the losses and bolster the markets—and it’s quite possible that a simple rate cut wouldn’t solve the immediate problem of investors holding subprime mortgages that are worth a fraction of their true value, and bought them with heavy leverage to boot—then he’ll be like the Wizard of Oz when Toto pulled the curtain back. He’ll be a mere mortal with no magic left. After all, if rate cuts don’t work—and Wall Street realizes rate cuts aren’t working—there will be a full-blown panic, every man for himself.

Plus, if he cuts rates now based solely off what we know at this hour…

Plus, if he cuts rates now based solely off what we know at this hour, it’ll look like he’s just bailing out hedge funds, private-equity funds, and the wealthy investors who are their clientel. Risk is a part of investing, and Bernanke has to let investors who made bad bets suffer the consequences. To cut rates and bail out hedge funds, is to encourage more risk-taking like we’ve seen in recent years – subprime mortgages, highly leveraged buyouts of companies – because investors will assume they have a “Bernanke put” ready to bail them out of future jams. Funny how capitalists preaches risk-taking until their bets go sour, and then they want to socialize the losses.

Bernanke is doing the right thing: Reaching straight into the pages of those economic textbooks he wrote as a college professor and engineering a big money dump—witness the massive amounts of liquidity the Fed is pumping into the system, and the Fed’s statement earlier today that it will intervene daily for the next two weeks, to help provide a cushion to the markets. Bernanke’s prescription of a “money drop”—which in a homage to legendary economist Milton Friedman, who conceived of the concept, Bernanke laid out in a famous speech some time back—earned him the nickname of “Helicopter Ben.” Fly, Ben, fly.

Of course, all bets are off if problems continue to snowball. Moody’s Investors Service issued a report earlier today raising the possibility that a major hedge fund blows up from the subprime mess—similar to the 1998 meltdown of Long Term Capital Management, which pushed the financial system to the brink. But I suspect that still might be enough to push Bernanke into action. Chances are he’ll first convene all the Movers and Shakers on Wall Street—as the Fed did back in 1998—to provide liquidity to the fund, or at worst, to buy the remaining assets, so there’s an orderly liquidation.

Of course, if matters keep getting bad enough--and we have the kind of "calamity" that Fed regional president William Poole says is the bar--the Fed can’t be too academic. It’ll have to jump in with a rate cut. But not now.

P.S. If it provides any comfort to those worried that the U.S. is on a path toward a depression, Bernanke has spent a fair bit of his academic career studying the causes of deflation and the 1929 Great Depression and the mistakes that the Federal Reserve made back them that contributed to the depression. For anyone interested, he discusses deflation and the depression in these speeches.

P.P.S. A tip of the cap to The Daily Reckoning web site, which came up with concept of the Bernanke action doll, which I used at the beginning of this entry.

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