First, the monetary policy: the overnight rate was reduced by 75 basis points in a "surprise" action by the Fed, and another half-percent cut is expected at the next regular meeting. The main impact is that Wall Street will momentarily stop screaming, "You're our bitch, Ben, and don't you forget it!"
Next comes the fiscal policy: the House and the Administration agreed to "compromise" on an "economic stimulus" bill. Certain Democratic members of the Senate will bloviate on the need for an extension of unemployment insurance before they take their seats and vote for "the best package we could get." Certain Republicans will bloviate on the intolerable expansion of the federal deficit, then vote to further expand that deficit with continued funding of the Iraq fiasco.
Neither the monetary policy nor the fiscal policy will bail our economy out of the mess its in, and the best we can hope is that they do nothing at all rather than make things worse. Let's begin by looking at monetary policy, and save the fiscal policy for another day.
Who controls the money supply?
Traditionally, a cut in the overnight rate ripples through credit markets and leads to generally lower interest rates, expanding the money supply by making it easier to borrow. Businesses and individuals use easier credit to buy more goods and services, which stimulates the economy. Sadly, these are not traditional times. Because of government's growing failure to regulate financial markets, the Federal Reserve lost control of the money supply.
The origin of the current credit crisis is not that it was too hard to get credit, but too easy. We're all familiar with the subprime mortgage fiasco -- banks extended credit to people who had no chance of making their mortgage payments once their adjustable rates reset at higher levels, then repackaged those flawed mortgages as supposedly "safe" securities which were sold to investors. The banks took their profits, the investors were left with the bad paper, and the increased demand for housing over-inflated its price -- the "housing bubble." Many who actually could afford their first mortgages borrowed against the inflated values of their homes with second mortgages and home equity lines of credit. When the bubble began to burst, and housing prices fell, some found they owed more than their homes were worth.
Less a focus of the media, but obvious to anybody who wasn't asleep, standards for other sorts of loans also declined rapidly. Our mailboxes were filled with "pre-approved" credit card applications, and auto loan offers bragged, "Bad credit? No credit? No problem!" While it's true that the 2005 change in the bankruptcy law gave the banks more protection from defaults on credit card debt, you still can't get blood from a stone. More and more families, including many who hold conventional mortgages or none at all, have debts they cannot pay.
Financial institutions like Citigroup and Merrill-Lynch have been "writing down" billions of dollars in debts they never will collect. So far, the losses come from subprime mortgages they were unable to securitize before the housing bubble burst, but we can expect even more write-downs from credit card defaults and other debts. A write-down represents a loss of liquidity. Every write-down means there is less money to lend.
Citigroup, for one, has been raising new capital by selling preferred stock to foreign investors, including sovereign wealth funds. Preferred stock is not voting stock, but it pays a guaranteed dividend. We don't know how much Citigroup will be paying for its bailout funds, but no matter how far the Fed cuts the overnight rate, interest rates at Citi will have to be high enough to cover its new expenses.
Also, no matter how far the Fed cuts rates, banks will not go back to the kinds of lending practices that caused their current problems. Quite probably they will be extremely conservative for a while, and credit will remain tight. New mortgages are being written for those with good credit, but primarily to refinance existing mortgages at lower, fixed rates -- not to buy refrigerators, second homes, and Hummers.
The recession is here, and it won't be going away very soon. Our central bank and our government, by failing to regulate the financial industry, relinquished control of the money supply to a self-serving, greed-driven corporate culture. We'll see if those elected next November have the strength of character to restore the regulation necessary to avoid this kind of market failure in the future -- no matter how much of their campaign funds came from Wall Street.