from The American Prospect:
The Fed as Enabler
For more than two decades, the Federal Reserve has been the prime enabler of a dangerously speculative economy. If we dodge this bullet without addressing the deeper threats, there will be more bullets to come. Robert Kuttner | September 25, 2007 | web only
Federal Reserve Chairman Ben Bernanke, like Alan Greenspan before him, has acted to keep a credit crunch from turning into a depression. The stock market liked the Fed's half-point rate cut, and experts have generally praised Bernanke's determination to do whatever it takes to contain the crisis.
But the turbulence is far from over, and in a sense the Fed is cleaning up its own mess. For more than two decades, the Federal Reserve has been the prime enabler of a dangerously speculative economy. If we dodge this bullet without addressing the deeper threats, there will be more bullets to come.
Here's the basic problem: Since the late 1970s, financial institutions have invented exotic ways of extending credit and taking big speculative risks. For example, bonds backed by packages of mortgages are not like traditional bank loans. In a crisis, their value can plummet. Likewise the other derivative instruments heavily traded by hedge funds.
In the old days, bank examiners could look at a bank's portfolio of loans, assign a precise degree of risk, and require banks to hold adequate reserves against losses. Today, much of what banks hold is a financial black box. Nobody knows what this paper is really worth. And just as all this risky innovation was proliferating, Congress made matters worse by deregulating much of the banking sector, reflecting the prevailing view that financial markets could regulate themselves. Up with markets, down with government!
The Federal Reserve, however, is part of the government. And every time one of these new financial fads blows up on its sponsors, in rushes the Fed to countermand the market's verdict because of the larger risks to the economy.
When banks lost billions on Third World loans in the 1980s, the Fed came to their rescue. When Citibank was under water in 1990, the president of the Federal Reserve Bank of New York personally undertook a secret mission to persuade a Saudi prince to pump in billions in capital as a passive investor. Sure sounds like government intervention to me. ......(more)
The complete piece is at:
http://www.prospect.org/cs/articles?article=the_fed_as_enabler