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Welfare for Wall Street

By Thomas Palley | January 28, 2008

Wall Street bull. Photo by Kate (CC).

The Federal Reserve's recent surprise decision to lower its short-term interest rate target by three-quarters of a point has received much attention. Most commentary has focused on the idea that the Fed is trying to stimulate spending in the hope of preventing a recession. Overlooked, and equally important, is the fact that lower interest rates raise asset prices, which is something Wall Street desperately needs to prevent a systemic meltdown.

The Federal Reserve is right to play the interest rate card aggressively since the economy-wide costs of a financial meltdown are so large. But let's not fool ourselves about Wall Street and free markets. The Fed is using its government-granted power of fixing interest rates to bail out Wall Street. That is welfare, Federal Reserve-style.

Normally, economists focus on the effect of interest rates on business investment and consumer spending. The thinking is that lower rates cause increased spending, albeit with long and variable lags, and the net impact is also highly uncertain and contingent on the state of confidence.

However, another feature of lower interest rates is that they increase the price of fixed income assets. Thus, when interest rates go down, bond prices go up, and that is critical for understanding recent Federal Reserve policy moves.

The U.S. financial system is currently deeply stressed. Growing perceptions of heightened default risk on mortgages and consumer debts have caused large price declines for securities backed by these assets. That in turn has caused massive losses at banks and insurance companies, eroding their capital. This erosion has placed many firms in danger of regulatory insolvency, unable to meet capital requirements. Some are in deeper danger of bankruptcy with the value of liabilities exceeding assets.

The problem is acutely visible among bond insurers, where rising default rates have reduced asset values while simultaneously increasing potential payouts on insured securities. If the bond insurers are downgraded, this could trigger a cascade of losses that could fracture the system. This is because insured bonds would fall in value, thereby wiping out further capital.

This possibility means maintaining asset prices, and preventing further mark-to-market losses, is critical. The Fed's problem is that as quickly as it has been lowering the federal funds rate, default rates on mortgage and consumer debts have been rising. Consequently, rising credit risk has offset the effect of a lower federal funds rate, so that asset prices have remained weak.

Moreover, there are pitfalls in the low interest rate policy. On the one hand, lower rates increase bond prices and also reduce defaults on adjustable rate mortgages. On the other hand, lower interest rates could trigger a wave of mortgage refinancing by those good risks still capable of refinancing. That would cause prepayment losses to holders of existing mortgage-backed securities, while also concentrating the proportion of remaining bad risks. The net effect is prices of mortgage-backed securities could fall further.

The fact that Wall Street needs this helping hand has important public policy implications. The existing system of regulation by capital requirements helps discipline risk-taking, but it has proven inadequate. The problem is individual firms do not take account of the impact of their risk-taking on others, so that the system takes on too much risk. This problem can only be solved by a system-wide regulator who monitors and limits total risk-taking. Yet, that is exactly what the Federal Reserve has rejected during the last twenty-five years of deregulation.

Remedying this failing calls for deep regulatory reform that is nothing less than paradigm change. This is something the Fed will resist and Congress will have to push. But until deep regulatory reform is enacted, the welfare for Wall Street problem will persist.

© 2008 Thomas Palley. Reprinted with kind permission.

Read More: Business, Economy, Finance, United States, Americas, Global

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