Will the Fed’s Medicine Work?

As I write this, the Federal Reserve has announced a huge new program to buy various kinds of debt designed to lower interest rates for home mortgages and other loans (such as securitized consumer loans). This action is another major step in the new era of the proactive Fed that puts large amounts of “Fed-created” money into the economy. The Fed money is intended to restart the seriously sick real economy by providing credit not available from the private sector.

Fed activity is unprecedentedu2013a new activism never seen before in the history of the United States. Fed Chair Ben Bernanke, a scholar before his venture into the political world, had as one of his main scholarly interests a study of the Great Depression and what the Federal Reserve should have done to help ease that economic disaster. Obviously what he discovered was that the Fed has the power to do all sorts of interventions to help create credit and avoid market freeze-up, an authority that was little used 80 years ago.

Two key questions can be raised about the new Fed activism: Will its activities actually help prevent a depression, or just delay it? And will such a large intervention create an inflationary bubble due to the creation of new money to fund it?

Anyone who is involved in running a private sector business, including, of course, banks, will have to try to answer these questions in order to be prepared for the future economic environment. Since no one I know can answer these questions definitively, even though there are many who think they can, the best we can do is make an effort to understand the potential threats and make an educated guess on what lies ahead.

Will the economy get worse once the Fed withdraws its many supporting efforts? Today, practically the entire economy is backed by U.S. government guarantees. Will the private credit market replace the government when we have to go back to relying on “normal” private sector credit? My guess is that if the Fed is slow and deliberate about reducing its activities (sometime after the panic on credit has worn itself out), the private sector will replace much of the Fed support. Skillfully done, and this is a very skillful Fed, it will prove that the chairman’s studies produced a real basis for the new Fed to institute a “total intervention” policy. The new Fed policy hopefully will make a recovery possible with less economic pain than we would have felt without it.

But what about the possibility of a major inflationary bubble caused by all the money (credit) created to carry out these intervention policies? The chairman has repeatedly said that most of the new credit is short term and can be reduced quickly if need be to diminish the inflationary threat. He may be right, but that depends on the Fed’s willingness to withdraw its support-not a popular decision. Furthermore, inflation does not depend only on the Fed. The U.S. government is running a trillion-dollar deficit, which is clearly inflationary in the long run.

While Fed action is important, the greatest threat of inflation comes from the failure of the government to get the deficit under control in the near term. It’s much easier politically to push a stimulus program (a shot of dope) than it is to cut government spending. When the system needs to cut expenditures to avoid inflation (detox), the many who have been enjoying the benefit of government largess will fight very hard to slow reducing expenditures.

The president has shown he is aware of the problem and has promised to cut the deficit in half by the end of his first term. His ability to make good on that projection (together with quick Fed actions) will certainly help the cause of inflation control. My experience in government (President Ford and 50-plus vetoes of overspending bills) says it can be done, but it takes a president and a Fed chairman who are willing to make enemies of some of their best supporters.