On Sunday, Fed officials raised the stakes by offering investment banks a new loan program without any explicit size limit.
These moves, along with a $30 billion credit line to help JPMorgan Chase take over the failing Bear Stearns, is fraught with more than financial risk.
The biggest danger is damage to the Federal Reserve’s credibility if it is seen as unwilling to let financial institutions face the consequences of their decisions. Central banks have long been acutely sensitive to “moral hazard,” the danger that rescuing investors from their mistakes will simply encourage others to be more reckless in the future.
Cane himself goes even further:
Propping up banks and cutting rates to near zero? To cynical ears, that sounds a lot like the policies that marked Japan’s decade-long economic malaise after its market bubble burst.
I’d love to see Edmund Andrews walk over to Bear Stearns right now and try telling the bankers there that they’re not facing the consequences of their decisions. Or maybe talk to a few BSC shareholders and tell them that they’ve been bailed out by the Fed. What happened on Sunday was somewhere in between a facilitated liquidation and a takeunder; anybody making the moral hazard play was devastated on Friday and wiped out by Monday.
I’m similarly skeptical about the idea that the Fed is "propping up" Bear Stearns. For a couple of months until it can be deleveraged and subsumed into JP Morgan, perhaps. But that’s a world away from allowing banks to operate for years while marking distressed assets on their balance sheets at par, which is what happened in Japan. The Fed was happy leaving the carcass of Bear Stearns to the wolves at 270 Park: this was anything but a "propping up" operation.
As for the near-zero interest rates, well, we’re still 200bp away from zero, and I don’t think anybody anticipates that rates will stay this low for years, like they did in Japan. One big problem in Japan was that inflation stubbornly refused to show up, despite zero interest rates: I don’t think that’s going to be a problem in the US, and if it is, I’m sure that Bernanke’s perfectly willing to print some money to make modest inflation appear.
So I think all these worries about moral hazard and decades-long economic malaise are overblown. If there is a decades-long economic malaise in the US, it will be despite the Fed’s best efforts, not because of them.