John Makin: Cost of Avoiding Recession is Too High

Excerpt from John Makin's latest commentary:

...the cost of avoiding recession after the biggest housing bubble in American history has burst is too high. It will involve rewards to those who took excessive risks that will only result in more underpricing of risk in the future, and therefore larger bubbles and, ultimately, a more unstable economy that underperforms expectations.

I am not suggesting that the Fed should stand idly by as economic growth slows while inflation remains stable or falls further. The Fed's decision to reduce the fed funds rate by 50 basis points on September 18 was tied to an observation that the economy was slowing rapidly and that the disruptions in financial markets would exacerbate that slowdown. An aggressive move was necessary to initiate preemption of a self-reinforcing, dangerous, and dynamically unstable downturn whereby a housing mortgage crisis slows the economy; a slower economy intensifies the housing mortgage crisis; and the economy, in turn, slows still further. To avoid that outcome, the Federal Reserve will undoubtedly be reducing interest rates more rapidly in coming months, probably down to 3 percent by the middle of next year.

The Federal Reserve should continue to keep its distance from Secretary Paulson's super-SIV proposal. Citibank, the major beneficiary of a superfund bailout, is a depository institution and therefore the direct responsibility of the Federal Reserve and not the Treasury. The super-SIV proposal, as already noted, appeared on the very day that Citibank announced a sharp 57 percent drop in its third-quarter earnings and during a week when Bank of America and Wachovia also reported very weak earnings. Clearly, the Fed shares former chairman Greenspan's view that the SIV problem is not akin to the Long-Term Capital Management meltdown in which it intervened in October 1998. Perhaps the criticism at the time regarding the moral hazard problem entailed by the Fed's intervention, even at that point, has left a mark on the Fed's thinking.