Pearlstein Looks for a Fed Bailout

If financial markets are frothy for a while and then revert to sensible levels

but don’t overshoot – then does that constitute a fully-blown

financial crisis? Steven Pearlstein certainly

thinks so, in this morning’s Washington Post.

The gist of his argument is that policymakers should step in, now, to rescue

the markets from themselves. And if the markets really are having a devastating

effect on the economy, then maybe that’s the right thing to do. (He sounds a

bit like Jim Cramer: no, I don’t want to bail out my sell-side

buddies, I just want to help poor homeowners.) But I didn’t hear Pearlstein

calling on the Fed to raise the discount rate when markets were going up. And

in general central banks have a heard enough time managing inflation; asking

them to manage something as unpredictable and irrational as the financial markets

is asking far too much.

The beginning of Pearlstein’s column is a recitation of financial-sector activity

in recent weeks: stock markets going down, the yen going up, that sort of thing.

Now I don’t think anybody would say that stocks are undervalued at present levels,

or that the yen is overvalued. This is only a financial crisis if you assume

that everybody bought at the top of the market and has therefore lost a lot

of money. But the S&P opened the year at 1,1418; it now stands at 1,411.

Long-term investors are still sleeping quite well at night.

To be sure, there are other indicators which are a long way from normal, mainly

at the ultrashort end of the yield curve. The money-market and commercial paper

markets have seized up in a very worrying way – but global central banks,

with their large liquidity operations, seem to be responding to that in textbook

fashion.

But don’t you know that this credit crunch is having real effects on the real

economy?

It’s to the point that, according to the Financial Times, Goldman Sachs and

Deutsche Bank have withdrawn their offer to raise $1 billion for MGM studios

to finance production of films including "The Hobbit" and the next

"Terminator" and James Bond movies.

Er no, it really isn’t to the point at all. Goldman Sachs and Deutsche

Bank are not the kind of entities which should be involved in the business of

film production, and the fact that they were getting involved was just another

sign of the bubble. The fact that they’re now having second thoughts is a sign

of the real economy moving back to "rational" from "silly".

Pearlstein tells us that "financial markets now drive the real economy

every bit as much as economic factors drive financial markets", which is

true, I guess, if only because economic factors don’t drive financial markets

very much at all. Global financial markets have in recent years been driven

much more by liquidity than by fundamentals, so it makes sense that if and when

that liquidity dries up, then the markets will fall. In the real world, however,

which is increasingly dominated by services rather than goods, I fail to see

that rising credit spreads will have any effect whatsoever on soaring passenger-miles

in the airline industry, say, or Americans’ seemingly insatiable appetite for

nail salons.

That said, I agree

with Pearlstein on the Fannie and Freddie front – yes, they should be

allowed to buy more mortgages and thereby help out on the mortgage-liquidity

front. And I also agree

with Pearlstein that it would make sense for the Fed to cut its discount rate.

But I don’t think it’s the job of the Fed or anybody else to buy yen in an

attempt to bail out speculators losing money on their carry trades. (Update:

As tinbox points out in the comments, this doesn’t even make

sense. If the Fed wanted to bail out speculators, it would have to sell

yen, not buy yen.) And I don’t even think it’s right for US and European central

banks to hint at future rate cuts if that’s not genuinely on their agenda. Pearlstein

says that doing so

would reassure uneasy businesses and consumers that economic policymakers

are not so intent on "punishing" investors and lenders for their

bad bets that they are willing to force billions of innocent bystanders to

suffer as well.

But policymakers aren’t intent on "punishing" anybody – they’re

just saying that speculators who gain from asset prices rising should also occasionally

lose from asset prices falling. And right now, I see no indication that "billions

of innocent bystanders" are really suffering at all.

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