Federal Reserve Board Chairman Ben S. Bernanke is facing his greatest crisis since taking over from Alan Greenspan.
However, his room to maneuver is limited.
To a certain extent, Mr. Bernanke is trapped between a rock and a hard place. The rock is the necessity of preventing the financial markets from congealing and triggering, at the very least, a recession. On Aug. 10, a freeze-up of the financial system seemed a very real possibility.
While that possibility seems to have faded for the present, it could re-emerge if one of the other bubbles — hedge fund, leverage buyout/private equity or infrastructure — should suddenly begin to deflate.
The hard place is a bailout of risk takers who gambled on subprime mortgages and lost. A central-bank rescue would serve only to spur some investors to continue their reckless behavior by eliminating fear as an inhibitor.
Mr. Bernanke’s dilemma was caused in part by the actions of his predecessor, Alan Greenspan, who stepped in during the October 1987 crisis, again in 1998 during the meltdown of Greenwich, Conn.-based Long-Term Capital Management Inc. and once more in 2001 when the Internet bubble burst.
These interventions, though apparently necessary, created precedents that risk takers may have depended upon — at least subconsciously — as the current bubble expanded.
Further, the financial system has been awash in liquidity since 2002, partly as a result of the Fed’s tech bubble bailout. Ironically, the success of the Fed and the Bush administration in keeping the post-tech bubble and 9/11 recession a mild one prevented a worldwide recession and kept money pouring into the United States from overseas. But an unintended consequence was foiling the Fed’s efforts to dry up excess liquidity.
Mr. Bernanke and his colleagues resisted the temptation to cut the fed eral funds rates Aug. 10, only three days after deciding to hold them steady. Instead, they injected reserves into the banking system. That was a clever move.
It was a subtle signal that the Fed was paying attention — that it did not believe that the situation was critical. Also, injecting reserves signaled that the market would be allowed to work its way through the problem.
The board’s action let banks know that they should lend to creditworthy borrowers, while banks who gambled too much on subprime mortgages would be allowed to fail.
Cutting the fed funds rate would have sent a signal that the Fed believed that the situation was indeed critical, perhaps worsening the crisis. But it would also have coddled foolish lenders, borrowers and hedge funds.
When the reserve injection appeared not to be working quickly enough, the Fed then cut the less powerful discount rate, another measured step.
So far, Mr. Bernanke and his colleagues appear to be handling the subprime-mortgage debacle with a sure touch. It suggests that ordinary investors should have increased confidence in the new Fed chairman. This confidence will continue to grow if Mr. Bernanke continues to maneuver with skill over the coming weeks.
