Uncle Ben's Instant Nice: Just Add Hot Water?

Last Friday, in what amounts to a publicity stunt, Ben Bernanke dropped the Discount Rate a full ½% to 5.75%. In reality, there was little substance to the move; it was done for dramatic effect ostensibly to calm the masses. The Discount (Window) Rate is the cost of funds loaned to accredited borrowers (usually member banks) directly through the Federal Reserve. Dropping the rate was a signal to speculators that the Fed stands at the ready to bail them out again. Friday's gesture only illuminates the unholy symbiosis between Wall Street and the Federal Reserve.

Now let's think about this situation. The Federal Reserve saw better than anyone the skyrocketing real estate values, driven by third-world lending practices (it could regulate). They were close enough to the siphon to hear that sucking sound of money borrowed against vaulting home equity and pumped into personal consumption. They do the math and know it was that exchange which fueled the past few years' growth. Mathematically it had to end badly. It's eerily reminiscent of the SS Internet Bubble which set sail on fear induced rate cuts and a run away margin credit bubble. After jawboning the problem into nonexistence failed, the Fed retreated to their first line of defense, drama for a non event, cutting the Discount Rate. Now the jig is up that hundreds of thousands of loans will default and it's time for meaningful damage control.

Ben now stands at the precipice and between a recession from the popping of the real estate bubble his predecessor christened or re-inflating the bubble by dropping the Federal Funds Rate. We have hot water, will we get the instant nice? Of course we will get the instant nice of a cut in the Federal Funds rate. The only way the Feds seek to prove their competence is cutting interest rates to bail out the market. Only this situation is too vast to fall for a bluff, too real to pretend a meaningless rate cut has some mythical significance and too grass rooted to be cheap moneyed away. We are most likely already in a recession and the sea sawing headlines are merely a distraction.

Someone loftier than I might let the Federal Reserve know that each bubble acts like a lotto where hundreds of thousands of future losers are lured into yet another opportunity for free money. These are the Animal Spirits (diagnosed by Adam Smith) that the Federal Reserve is meant to temper, not stoke. Perish the concept of actually preventing a credit bubble. By cutting interest rates the Feds will throw worse credit after bad in a vain effort to prolong the painful reality that we are far too overextended.