Why the Fed's Bailout Won't Work (Part 2)

The Fed bailout of Wall Street keeps getting larger and larger. Not only has the Fed lent J.P. Morgan thirty billion to take over Bear Stearns, but starting today, securities dealers can borrow money from the Fed on about the same low terms as member banks. The Fed also lowered the rate charged on such loans, and extended the repayment deadline to three months (from one). We haven’t witnessed this scale of bailout since the 1930s.

Will it work? The immediate goal is to stop the runs – runs on banks, runs on securities dealers, and the biggest run of all, the run on the dollar. Stampedes occur when lenders lose confidence that borrowers can pay them back – and worry that all OTHER lenders are losing confidence, too. So everyone runs to get their money out before everyone ELSE gets their money out.

Viewed in large terms, these runs are a consequence of how indebted America and Americans have become. We’ve been living beyond our means for some time now, borrowing to the hilt. This had to end at some point. Even the US dollar has become encumbered with so much international debt that – as the nation’s IOU – it has become endangered. Investors are getting out of dollars because they think everyone else is getting out of dollars.

Can the Fed pour enough money into the system to assure all lenders, domestic and foreign, that their own money (including money left in dollars) will be safe? It’s a tricky dance. If the Fed scares everyone into thinking that the crisis is larger than they otherwise thought, then the stampede gets worse. And by pouring money into the system, the Fed also may create the impression that the dollar could inflate away – losing its value because so many other dollars are on the market. That would only cause investors to dump more of their dollars and switch to euros or yen or sterling or gold or whatever else they can find to put their money into.

The speculative bubble that began to grow in 2003 when Alan Greenspan and company cut short-term interest rates to 1 percent and made money so cheap that every lender pushed money into the hands of any borrower who could stand up straight triggered all this. Housing prices have to drop another 10 percent, and big banks have to write off another $200 billion in worthless assets, if we have a prayer of getting through it – bailouts or not.