Deflating Balloon

One month ago this humble servant opined:

Rate cuts don’t work in this market. Despite the Federal Reserve's 3/4-percent rate cut, the highest since 1982, the Dow is more than 100 points lower as of this writing.

Prices are collapsing not because interest rates are too high but because a much higher discount for risk is being priced into financial assets. Put another way, if you were a bank lending officer, would it matter much if you charged 6%, 8%, or 10% on a loan if you thought the borrower had a good chance of defaulting? You can ask for more collateral, but those values are dropping as well.

Today Martin Feldstein echoes in the WSJ:

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

The collapse of the credit markets began last summer when the subprime mortgage crisis demonstrated that financial risk of all types had been greatly underpriced.

But the reason he's a professional economist is that he can prescribe as well as diagnose. Perhaps Dr. Feldstein, who is a Harvard professor and was Chairman of the President’s Economic Advisors under Ronald Reagan, will tell us how to get out of this mess. He ends:

The implication of this for Fed supervision policy is clear [bank examiners should be tougher]. The way out of the current crisis of confidence is not. We can only hope that those who predict nothing worse than a temporary slowdown are correct.

Thud....but on second thought why not? It's fashionable these days to think that hope is a strategy. © 2008 Stephen Yuen