Ben Bernanke in Dilemma Over Bank Bailout

Across the ocean the US Federal Reserve Board’s monetary policy committee needed no such briefing. Fed chairman Ben Bernanke had been cutting short-term interest rates in an attempt to ease the credit log-jam, to no effect. Longer-term rates remained stuck on high. So the Fed laid down its blunderbuss – rate cuts – and took aim at a specific target: the credit markets. Come to us with your AAA-rated mortgages, Bernanke told strapped financial institutions, and we will lend you in exchange $200 billion of the risk-free Treasury securities that we hold on our own balance sheet. And for 28 days, rather than the few hours, as is our usual custom.

Not quite the same thing as buying these mortgages from the banks, which would prefer to unload them permanently for cash. That would be a bail-out, something Treasury secretary Hank Paulson is eager to avoid lest it creates moral hazard, economists’ jargon for encouraging a repeat of bad behaviour. The Fed’s non-bail-out is aimed at driving up the price of mortgages to increase their valuation on bank balance sheets. That, along with the risk-free Treasury notes against which the banks can borrow cash, would enable the banks to start lending again.

All of which puts me in mind of the Clintons, who in a desperate bid to salvage Hillary Clinton’s Democratic campaign, decided to “throw the sink” at Barack Obama - which they have done, but with only limited success: Obama remains on course to win. Bernanke has now thrown the sink at the credit crunch. And with only limited success: share prices rallied and banks lined up to take advantage of his offer at an auction to be held on March 27.

There are four problems with all of this. The first is that bad news overwhelms good. The collapse of one of the Carlyle Group’s funds, and rumours of the impending demise of Bear Stearns, trumped Bernanke’s announcement.

The second problem is that the Fed is a tiny player in the mortgage market. The $200 billion of mortgages Bernanke will be taking on are a drop in the ocean that is the $11 trillion mortgage market. And he has only another $400 billion in Treasurynotes to play with - if he is willing to have these mortgages make up his entire stock of assets.

Third, so long as house prices continue falling, the value of mortgages will continue falling. The Fed can’t do much to stop that decline, and we seem to have a long way to go before house prices reach some bottom, unsold houses are absorbed, and the market turns up.

Finally, the Fed might be fighting yesterday’s war, when the problem seemed to be a liquidity crisis. The Fed first lowered interest rates to facilitate borrowing. No luck; long-term rates were immovable. It then made funds available to credit markets for very short periods on attractive terms. No luck; credit markets remained frozen. So now we have the offer of $200 billion of high-quality assets to replace those of lesser quality. Tune in after a few weeks to find out if this has significantly eased credit markets, or merely created a bit of euphoria in stock markets.

Meanwhile, the Fed’s critics are saying that the enemy is no longer liquidity, but the threat of insolvency. We have already had billions in write-offs, and hundreds of billions more of such “marking to market” is coming. So steep will these write-downs be that the banks will find they are bust - what they owe to depositors and creditors exceeds the value of their shrivelled assets. Unless they can get more capital, say the doom-mongers, they will have to shut their tellers’ windows.

So far, sovereign wealth funds have put up that capital, but even they do not have deep enough pockets to shore up the entire American banking system. Faced with a systemic collapse of the banking system, the government can do one of two things. It can flood the economy with cash, driving up inflation and the nominal value of the assets underlying bank loans. Lenders would get repaid, but in depreciated dollars. Fear of just such a devaluation has driven up gold to $1,000 an ounce, and the dollar down to record lows.

Or the government can nationalise the debt owed to the banks. Taxpayers’ funds would be conscripted, and pumped into failing financial institutions to prevent their collapse. Sound like Northern Rock? Or something like what the American government did when Continental Illinois, the nation’s seventh-largest bank, hit the rocks in 1984? Or what former Treasury secretary and Harvard president Larry Summers, now a hedge-fund adviser, says the government should “at least be thinking about”? Or what 32 of 51 economists surveyed by The Wall Street Journal say is now somewhere between likely and certain?

If it looks like a bail-out, and sounds like a bail-out, it is a bail-out. But “capitalism without failure is like religion without sin. It doesn’t work”, says Carnegie Mellon professor Allan Meltzer. Guarantee lenders against failure and they will lend and lend and lend, diverting resources to ill-conceived ventures, driving down productivity and living standards. Only if the shareholders are first wiped out, or if the taxpayers gain a real opportunity to profit in a recovery, can a government rescue package avoid becoming an invitation to a repeat disaster.