March 24, 2008 11:23AM

The Fed’s “Central Planning” Woes

Given the financial/​regulatory system that we have — which is a very important pre‐​condition — I grant the Fed and Treasury a TEMPORARY “coordinating” role to help tide over the current crisis. However, the initiatives and actions implemented so far appear unlikely to succeed.

I agree only with its role in the Bear buyout by JPMorgan. It is, by nature, a one‐​time action that does not protect Bear’s shareholders and operators but protects the financial system from unraveling further — similar to it’s actions re: LTCM. Even if it is repeated for another investment bank, it does not raise the issue of moral hazard because no such bank wants to end up like Bear.

However, the Fed’s new and almost direct support of mortgage backed securities through its primary dealers introduces another moral‐​hazard potential — likely to be a huge problem down the road, and especially because of the interest rate policy it is adopting.

Interest rate cuts are being overdone. Large cuts are continuing the Fed’s past mistakes of introducing greater uncertainty in market participants’ expectations. It is using the wrong (inflation fighting) tool to achieve its goal of systemic stability which has arisen from poorer visibility of asset quality. The added uncertainty will prolong the resolution of current credit/​liquidity shortages.

The longer that credit/​liquidity problems last, the more likely is the introduction of PERMANENT new financial market regulations — which would hinder efficient operation — in the very function that is key to resolving current credit shortage problems — the generation of price information.

Finally, Prof. Cowen’s recent NYT oped (“It’s Hard to Thaw a Frozen Market”) compares market pricing under capitalist and socialist systems. In brief, the argument is that socialist systems’ poor market pricing abilities appear to be reflected in the current credit‐​market woes of the American “capitalist” system. This comparison appears misplaced to me. The general U.S. economy may be relatively free and capitalist — but financial and credit markets are not quite so free.

Current credit market problems are not the result of pure and free market operation/​competition. We have a fiat currency whose supply and purchasing power is controlled by Fed interest rate policies. And it appears to have made serious mistakes in the process. This involves larger issues of whether asset prices should be objects for setting Fed policy and whether and how the Fed should respond to supply/​oil shocks. Fundamentally, however, financial market participants naturally don’t look to “the free” market to set their expectations about the dollar’s future purchasing power. Those expectations are set by a “central planner” — the Fed.