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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It's to the point that, according to the Financial Times, Goldman Sachs and Deutsche Bank have withdrawn their offer to raise $1 billion for MGM studios to finance production of films including "The Hobbit" and the next "Terminator" and James Bond movies.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. 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.

Source: Pearlstein Looks for a Fed Bailout