How the Fed Can Ease the Crisis

There are limits to the Federal Reserve's power, but Bernanke still has lots of ammo left to stop the downward spiral

Never underestimate the power of a central bank, which can conjure up money from thin air. Federal Reserve Chairman Ben Bernanke and his fellow central bankers around the world cannot stop asset prices from falling, nor do they want to. They realize markets need to find a firm bottom before they can begin to recover.

What the central bankers can do, and are determined to do, is keep the banking system operating effectively even as trillions of dollars in wealth evaporate and panic weakens or kills stalwarts of the financial Establishment such as Fannie Mae (FNM), Freddie Mac (FRE), Merrill Lynch (MER), Lehman Brothers (LEH), and American International Group (AIG).

Some people are worried that a crisis of this magnitude is too big for the Federal Reserve System, which has a relatively paltry $900 billion in assets on its balance sheet. But the tools to deal with crises like this exist, and they've been proven to work. Says Charles Goodhart, a monetary policy expert at the London School of Economics & Political Science: "An intelligent central bank, well managed at the top, ought to be able to stop" the kind of downward spiral that gave Japan its deflationary lost decade of the 1990s.

Power and Constraint

There's no question that credit markets are more dysfunctional than they have been in generations. Banks are afraid to lend to one another, and investors are fleeing to the safest of assets, driving the yield on the three-month Treasury bill on Sept. 17 to less than one-tenth of 1%. Investors are fleeing from any institution that depends on short-term borrowing to finance long-term, illiquid investments—including investment banks Goldman Sachs (GS) and Morgan Stanley (MS), whose shares came under heavy selling pressure on Sept. 17. The danger is that even healthy, solvent institutions will be dragged under because lenders will refuse to supply them with the funds they need to stay in business.

The good news is that Congress founded the Federal Reserve in 1913 to deal with precisely this type of crisis. The Fed and other central banks are unique in their exclusive power to create money. In the current emergency, the Fed is manufacturing (virtually) tens of billions of extra dollars to slake the thirst of cash-hoarding banks and make emergency loans. The Fed didn't need to scrounge around in a cash drawer for the up to $85 billion that it's lending to insurance giant American International Group. It is simply noting in its books that henceforth, AIG can draw on an $85 billion line of credit that it didn't have before.

And the Fed has plenty of ammunition left. For one thing, it could cut interest rates again. On Sept. 16 it chose to leave the federal funds rate at 2%, judging that lowering the rate now might spark higher inflation. But if the credit crunch continues to sap the vitality of the economy, inflation will cease to be an issue and the Fed will have free rein to drive the federal funds rate down almost to zero, if need be, by purchasing Treasury securities from banks. That would give those banks more money that they could then lend to businesses and consumers.

If a near-zero interest rate still doesn't do the trick, the Fed could flood the financial system with even more money by buying up other assets—not just Treasuries but riskier kinds of bonds and even, in an emergency, stocks.

There are limits to the Fed's power. Obviously, flooding the financial system with money risks inflation in the long run. That's why the Fed needs to drain extra reserves as soon as the economy stabilizes. There's a political constraint as well. The Fed risks losing its cherished independence if it gets too deeply involved in the sensitive issue of picking winners and losers.

In addition, fighting the credit crunch too aggressively would keep asset prices artificially high and prop up weak financial institutions that deserve to die, says Mark Gertler, a New York University economist. That would delay the recovery by leaving investors afraid to buy (because prices remain too high) and banks unable to lend (because they're still saddled with bad loans).

Another problem: Historically, the Fed's main tool for helping troubled institutions is to lend them money. But excessive borrowing is what got us into this mess. Meanwhile, U.S. investors aren't interested in buying new issues of bank stocks, and sovereign wealth funds that bought into the sector earlier this year have little appetite for throwing good money after bad.

That's where other branches of government may need to supplement the Fed's efforts. One idea is to create an agency to buy up bad assets, replenishing the banks' capital bases. If that's not enough, the next step would be what the Scandinavian nations did in response to a banking crisis in the early 1990s. They nationalized their big banks, later selling them back to investors for a profit. That's not a step to be taken lightly, nor is it a job for the Fed alone. Says Goodhart, the British economist: "If you're going to be supplying capital, it's got to be the Treasury that does it."

For now, though, it's comforting to know that whatever else happens, the Federal Reserve isn't going to run out of money.

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