The case for a Fed rate cut

By Thomas Palley

With Wall Street beset by a crisis of confidence and the mortgage-backed securities market seizing up, there is urgent need for an immediate emergency interest-rate cut by the US Federal Reserve. This sudden need has also revealed how today's financial system places monetary policy in bondage to markets. That system has evolved over the past 25 years with the Fed's approval, and the current crisis starkly reveals need for reform.

An emergency rate cut is needed to prevent the subprime-mortgage meltdown from spiraling into a full-blown recession. By immediately lowering the base cost of credit, a rate cut could make existing mortgage securities more attractive to investors and also encourage continued flows of mortgage finance for the housing market.

Such continued financing is critical. In its absence, mortgage availability will shrink and mortgage rates rise, thereby deepening the US housing-market slump. That is likely to trigger additional mortgage defaults and reductions in construction activity, thereby perhaps even causing a recession. In this event, the spiral of credit deterioration stands to deepen, jumping from the subprime-mortgage market to the entire US housing sector and the US economy more broadly.

In response to this threat, the Fed has already moved to inject significant temporary additional liquidity into money markets, in effect lending billions of dollars to banks to prevent their having to make further asset sales under distressed conditions. Central banks in Europe, Japan and elsewhere have done the same. However, because the costs of recession promise to be so large, the Fed must also move to cut rates.

Less than two weeks ago, Fed policy was focused on containing inflation. Now, within the blink of an eye, the evaporation of confidence among Wall Street lenders has created conditions warranting an emergency rate cut to save the US economy. This power of financial markets is rooted in a new business cycle that emerged in the 1980s and which has made the US economy increasingly dependent on debt to fuel expansions. The creation of debt in turn relies on highly leveraged financial intermediaries that package and repackage loans while promising liquidity they are unable to deliver. As a result, the system has become fragile.

Increased financial fragility is one feature of the new system. A second and worse feature is that increased debt is part of a complex for shifting value from the real sector to the financial sector - a phenomenon known as "financialization". This increases profits in the financial sector at the expense of the real economy. Meanwhile, the new structure also implicitly compels monetary policy to rescue the financial sector if it gets into trouble. This amounts to a policy stick-up whereby the Fed is forced to provide the getaway car for fear that not doing so will result in even greater economic damage.

Today's system places monetary policy in a double bind. In good times the Fed is forced to raise interest rates to maintain lender beliefs that inflation will remain low. Those beliefs ensure that investors are willing to make the loans needed to fuel the system. However, the result is higher interest rates and curtailed expansions that hold down wages and employment, thereby limiting the share of productivity growth going to working families.

In bad times, such as we are now experiencing, the Fed is obliged to come to the rescue of lenders for fear that if they stop lending the US economy will tank. Moreover, this fear deepens the greater the level and burden of debts. Worse yet, such intervention creates a problem known as "moral hazard" that can aggravate the need for rescues.

Having the Fed intervene to prevent financial meltdowns tacitly puts a floor under financial markets. That floor acts as a form of insurance for investors and speculators who, knowing that they are protected against large losses, then channel more funds into even higher-risk investments and loans. The Fed has actively promoted the new system through deregulation. Its claim has been that the risks of the financial system imploding are less because risk is spread. That claim is now being shown to be false.

For two decades, working families in the US have felt the effects of the policy head-lock imposed by financial-market demands for ultra-low inflation. Now, financial markets are exercising their other demand for interest-rate cuts to preserve asset values to prevent recession.

The threat posed by the current crisis is such that the Fed should meet this demand. That means immediately cutting rates and continuing to provide emergency liquidity judiciously. However, once the storm passes, the US Congress and the Fed must address the systemic problems and policy distortions that have been exposed by the current crisis.

Thomas Palley is the founder of the Economics for Democratic and Open Societies Project.