We should not bother summarizing the facts; still we will. During the last seven months the Federal Reserve Bank of the United States has pushed the Federal Funds rate (FFr) to negative real values; it is now offering American banks to swap risky securities of uncertain value for safe Treasury securities of certain value, while at the same time engineering the acquisition of one bank by another. The bi-partisan "federal stimulus" plan is currently underway: American taxpayers are being mailed checks of varying amounts, the total value of which is about 1% of GNP. The question we ask is: does the whole package of government interventions make sense, given the nature of the crisis? Apparently, it does: most commentators are applauding the choices, and the few people uttering criticisms are mostly anti-market types used to blame free markets, competition, capitalism and globalization for everything painful, from financial crises to diarrhea. Among experts, the unanimous consensus is that these choices are the correct ones. We dare to disagree. Today we illustrate the reasons for our disagreement; next time we discuss alternative policies.

There are three parts to the overall policies adopted: the fiscal giveaway, the cut in interest rates and the asset swap. Let's consider them in turn.

Fiscal giveaway. This is receiving scant attention as most people discount its electoral nature. Too bad because, until now, the fiscal stimulus is the most expensive arm of the three-pronged government intervention strategy. Increasing the disposable income of about 90% of American households of about 1.5% will make no difference on defaulting mortgages, but increasing government debt does signal that the strategy of getting out of financial troubles by piling up new debt is not yet over. Nobody - but Paul Krugman: GWB and PK are, for once, on the same side - claims that the impending recession is due to a sudden drop in aggregate demand. If anything, the crisis is due to a prolonged excess demand for housing fueled by an extraordinary amount of cheap credit made available by the Fed, which pushed up housing prices past the level a sizable fraction of American households could afford, given their current and expected nominal incomes. In other words, the current crisis is due to a "localized asset-inflation" generated by reckless central bank lending, and its magnification through "moral-hazard-plagued" financial innovations from the banking sector. Because the nominal prices of a number of real and financial assets are completely unrelated to their future payoffs - and because nominal income is too low to provide the resources needed to serve the debt those assets were purchased with - something must give. Either the nominal values of those assets drop - via asset deflation and bankrupcies - or nominal income grows extremely fast - via generalized inflation.

The bursting of the bubble that localized asset-inflation brought about is causing a sharp slowdown of real economic growth. This happens because the realization that prices had gone passed the level "would be" buyers could afford took place after the production of the houses had already been completed or, at least, had started. The resources so invested are therefore wasted: they produced goods people do not want or cannot afford; hence the owners of those resources are receiving compensations that are much lower than they expected. From this the recession: assets must be devalued and resources (factors of production) must move away from the unwanted/unaffordable goods and toward goods that households and firms both want and can afford. Even assuming that the increase in purchasing power the fiscal giveaway is supposed to produce will not be washed away by an increase in prices of the same proportion, it is certainly not by raising aggregate demand for burgers, shoes, or airplane tickets of about 1% that such reallocation of resources will become less painful. More important: the giveaway will do nothing to reduce the impact of the financial crisis brought about by the real estate crisis. This is due to the fact that a fraction of American households cannot afford the houses they bought, and are defaulting on mortgage payments; the banks holding the loans are therefore making losses. For a household defaulting on a $200K-500K mortgage, a once in a lifetime $1,000 of additional cash will make no difference. Bottom line: the fiscal giveaway cannot alleviate either the financial crisis nor the recession; it will only add a bit to the CPI.

Interest rate cuts. Since the Greenspan's years the fashion has been to measure the result of such interventions by subsequent movements in the stock market. Assurances to the contrary by local Feds' presidents not-withstanding, this has now become the way in which financial markets, and economic agents at large, interpret and evaluate Fed's actions. Because the current Chairman of the Board of the Fed has actually written papers trying to measure how market indices react to unexpected Fed's actions on rates, this common wisdom has been recently reinforced by actions such as the one on January 22, 2008; i.e. that the Fed should move interest rates to prevent the stock market from falling. There are absolutely no reasons to believe this makes any economic sense, nor the mandate of the Federal Reserve system is that of keeping stock market indices growing at some target rate. The ECB, wisely in our view, is basically ignoring the stock markets in its policy actions: price stability is its goal, not capital gains. In any case, if we had to judge the success of the Fed's policy by this metric, the verdict would be damning. During the last six months the Fed has cut rates six times, two of which could be reasonably considered "surprises". Stock valuations are about 15% lower than six months ago and they display no intentions of recovering in the near future. The only effect these cuts seem to have had, so far, is to increase volatility: relatively large "rallies" on the day of the announcement or the next one, followed by even larger drops right after. The proposition that the Fed is moving short term rates to affect stock prices - and that it actually has the power to affect stock's real valuations more than ephemerally - rests on the idea that movements of the short term rates can affect either the perception (in which case: for how long?) or the reality of aggregate risk. This is a very long shot, which goes well beyond the usual "output-inflation trade-off" kind of arguments and for which there is practically no theoretically consistent support, let alone favorable empirical evidence. How a sustained reduction in aggregate risk may be engineered by a 300 basis points drop of the FFr, escapes us. Unless, obviously, one is willing to believe the asset bubbles of 1997-2000 and of 2002-2006 - with the accompanying academic chatters [references piteously omitted] of "reduced volatility", "reduction of aggregate risk", "great moderation" and "higher assets evaluation" - were good things that the reduction of aggregate risk engineered by a lax credit policy brought us. Hence - even if the last ten years of US central banking may lead one to reasonably suspect that this was one of the motivations behind his predecessor's actions and that Mr. Bernanke is now forced to cope with the wrong expectations Greenspan created - we dare to assume this was not the purpose of Bernanke's recent choices.

A more realistic purpose may be that of stopping the growth in mortgage interest rates caused by the post-2004 Fed's policy. This is widely regarded as the pin that pricked the bubble the 2001-2004 policy of persistently low FFrs had previously created. As this is not the right moment to argue over the details of what caused what (one day or another it should be, though) let's leave this issue aside and consider how successful this policy may be. A reasonable argument is the following: a raising FFr increases both short and long term market rates. Because a sizable share of mortgages is financed with adjustable rates that are being reset after a few years on the basis of short term rates, this is causing the increase in default rates we are all the victims of. How do we stop the bleeding that defaulting mortgages are causing? Increasing borrowers real income by 10-15% is impossible, so let's try to lower the amounts they must pay. If we lower the FFr enough, mortgage rates (especially those on ARMs) should also go down, therefore alleviating the mortgage crisis. Right? Possibly, but not necessarily. Resetting does not take place continuously, but at fixed time intervals that, sometimes, are as long as one or two years. Hence, at least for a year after the FFr cut, no interest rate relief may possibly be forthcoming to borrowers: those that were defaulting during summer of 2007, still will, and those for whom resetting was due during the last six months are facing the same higher rates. Further, the market rates on which ARMs reset are not necessarily responding one-to-one to movements in the FFr (even when it comes to nominal short term rates the Fed is NOT omnipotent) and in fact they are not. They have gone down, but not as much as the FFr has. In other words, while lowering the FFr may appear to be a source of relief for troubled borrowers, it is clearly not quantitatively very significant. The Libor or the 1-year costant maturity Treasury rates have declined, but the risk spread has increased of about as much on both of them, thereby improving the situation only mildly and certainly not in the immediate future. Finally, and more importantly, mortgage rates are now at the same level (sometime higher than) they were a year ago, hence no chances of obtaining an advantageous re-financing deal thanks to the Fed lowering of the FFr. Refinancing at a lower rate, or switching from the risky ARMs to the less risky fixed rate loans, would be the desirable and natural solution for most troubled borrowers, but this solution seems to be out of question for the time being. In summary, while theoretically this channel could have a positive impact on the causes of the financial crisis, practically its impact is quite limited: it does not do damage, but it provides very little help. More importantly: maybe this is not too little (rates are down more than 300 basis points, after all) but this is certainly way, way too late. Which leads to the 100 trillion dollars question: what on earth is or was the economic justification behind the wild interest rates roller coaster of 2001-2008?

There is a third purpose for cutting the FFr: the Phillips curve, the inflation-output trade-off, the dream that never dies. Because, among macroeconomists and monetary theorists, this has become more a matter of faith than of rational discussion, there is little one can say. In our view the experience of 2000-2001 and the current one (not to speak of 1991) show that the Fed has no practical ability whatsoever to avoid a recession by lowering short term rates: whatever the forces causing the recession may be, once the Fed's thermometers signal its presence a recession is already underway. Models based on the assumption of rigid prices (the absolutely essential ingredient necessary to claim that a rate cut has at least a chance to prevent a recession) keep failing the quantitative test: no one has been even remotely able to produce a vaguely realistic set of parameters under which the "inflation-output trade-off" is of any quantitative importance and can be exploited by Fed's actions. The kind of price rigidities needed to make the trade-off empirically exploitable through interest rate cuts are of the order of 2 or 3 years: every American (or European, or Chinese, or Mexican) consumer, facing prices that change weekly if not daily, would find such a statement laughable. Still, most macroeconomists, especially those working at the banks of the US Federal Reserve system, take it very seriously: they must be too busy writing monetary models of price rigidities to afford the time to go shopping. One cannot avoid mentioning the irony of a theory claiming that rigid prices are the cause of this recession and that the latter will be cured by lowering nominal short term rates, when the recession is due to house prices falling too quickly and commodity prices rising too abruptly, following the bursting of a bubble engendered by ... excessive lowering of nominal short term rates!

Summing up: any visible success? Apparently not. As far as we can tell, the only thing that the Fed's policy of precipitously cutting rates has achieved so far is to scare the public opinion, making consumers even surer than they would be otherwise that a recession is coming and that all hell may break loose sometime soon. But, maybe, the effects of the lower interest rates policy will be visible in the future months, or in a year. Maybe, if the Fed had not lowered interest rates so much and so rapidly, things would be already worse. That is true, maybe. But one should observe that the ECB has not followed the Fed in its policy of cutting rates, and things in Europe are not going so differently than in the USA; if anything, they are going slightly better. Stock market indices oscillate up and down in the midst of a generally negative tendency, but they are less down than in the US; some countries, Spain possibly and Italy almost certainly, are heading toward a recession, but the first had been growing briskly for 14 consecutive years while the second is becoming Argentina, so it does not count. This does not mean things look alright in Europe; it simply means that, even six months later, having dramatically lowered interest rates by 300 basis points does not make much of a difference either for the real economy. To us this suggests it is about time to look somewhere else.

The asset swap. No one seems to be claiming that the TSLF and the PDCF have been set up to alleviate the recession by exploiting the output-inflation trade-off. They have been set up, we are told, to save the banking and payment system from a systemic crisis, the "domino effect", the collapse of the American, hence the world, financial system. Really? First off: the total value of US Treasury securities in the hands of the Fed was, at the inception of the crisis, 3/4 of a trillion dollars; it is now quite a bit less. At their opening, the two facilities have about $400 billion of Treasury securities available, max; in practice they have about $200 billion. As of March 23, the nominal value of just the Credit Default Swaps outstanding had passed the $40 trillion mark; JP Morgan and Citi together hold more than $10 trillion. Hence, if the words "domino effect" or "systemic crisis" are meant to describe things like "the market for CDS unfolds" because "bankers confidence" collapses, then TSLF and PDCF are like trying to save New Orleans from hurricane Katrina by telling people to open their umbrellas. If Citi alone becomes unable to serve its portfolio of CDS, the two facilities will be blown away immediately. In other words, IF the theorists of the "domino effect" mean what they say, THEN they better get ready for an overall nationalization of the US banking system. And, we add, IF that is the scenario the Fed has in mind, THEN it better starts doing something different from lending money to investment banks in exchange for pieces of paper of the uncertain value. On the other hand, IF "preventing the domino effect" is just another name for "keeping the guys on Wall Street afloat" without letting the citizens know, THEN the two umbrellas are just fine.

Next argument: the "domino effect" works in steps, so it is the apparently small collapses that must be avoided as they trigger bigger and bigger ones. For the dominant wisdom the counterfactual is obvious: IF lenders had not known that the Fed was going to engineer the JP Morgan purchase of BSC (thereby bailing out all its creditors), THEN the systemic crisis would have happened. No one can contradict such a counterfactual, hence we will not try. We note, though, that while the BSC crisis was unfolding there was no sign whatsoever of a run on the other banks (investment or not), or of symptoms of panic among depositors. The Fed has brokered a good deal for a bank with the justification of avoiding the collapse of another, and the consequent "domino effect". The "collapsing" bank is currently worth about $1.5 bn, and the quotation of the acquiring entity has gained about 20% since the deal was announced. Why on earth a central bank should meddle in this kind of private business escapes us completely, so let's leave it at that and return to the common wisdom counterfactual. There were, it is true, talks about Lehman and Goldman&Sachs being the next ones on line, which would not have been nice for the people there, and probably at a number of other places. Nevertheless, a couple of days later both banks engendered a (temporary) banking rally by showing numbers proving they were better off than expected. Is it too much to ask: what's preventing most or all "banks" from doing so? In fact, this seems to be, if not a 100 trillion dollars question, at least a 10 trillion one: the sub-prime mortgage crisis is now more than a year old, why is it that the Fed and markets' regulators still seem unable to have the banks' information disclosed and portfolios "marked to market" in any reliable sense? If it is "fear", "lack of trust" and generalized "asymmetric information" (normal people call them "lies" or "tricks") that prevent the markets from working and that repeatedly dry up liquidity, should we not have started a year (or more) ago to tackle THOSE problems?

Furthermore, we are told, we must avoid a repeat of Japan in the 1990s. Really? We will get back to the historical analogy later; now let us consider more solid rationales behind the asset swap policy. We understand it is not fashionable to talk about moral hazard these days, as moral hazard is just a theoretical concept practically minded policy-makers wipe off the table whenever the goings get tough. A "practical" and very "tough man" style argument (championed, together with the whole of Wall Street, by Lawrence Summers) is that the financial system stability and health is way more important than some deological argument about moral hazard and reputation, the relevance of which is negligible in dramatic circumstances such as these. As Craxi explained the Italians, while he was siphoning a good percentage of GNP in his and his friends personal accounts, primum vivere, deinde philosophari ... and in front of two expert authorities of such caliber, all we can do is to bow. Nevertheless, we would like to point out that what has happened since 2002 and has got us in this mess IS exactly what the "theoretical" moral hazard argument would have predicted in front of current Fed's policies and the "too big to fail" doctrine. Moral hazard, in other words, is not just a theoretical argument: it is a sad fact of business life, especially around Wall Street. A point in time must exist at which a country decides to bite the bullet and let the incompetent, or just plain fraudulent, companies fail to establish a minimum of reputation and avoid fraudulent behaviors in the future. Apparently, that point in time has not yet arrived for the USA, so let's just remind everyone of the open wound, an move on.

We hear that the asset swap is justified if one believes the assets that are troubling the major investment banks now will have more value soon. Call it Scenario 1, and say it is just a liquidity problem: the investments were sounds or almost so, but there is cash due out in the short run, which was not expected, and therefore the sound investments need to be kept alive by the Fed acting as the FDIC of investment banks. [For the well trained: think of Diamond and Dybvig JPE-1983 on a gigantic scale. Kiyotaki&Moore-like arguments would not work, for a variety of reasons we would be happy to discuss if the comments require it.] We don’t see any reason to believe this is the most probable scenario - why? Obvious: if they were good investments, why would mortgage holders default and lenders refuse to recontract on houses that will eventually become worth owning/financing? Recontracting is NOT forbidden, so why are not the two parts coming together and finding a way to reap the future gains? - still, we will pretend it is for the sake of the argument. The other possibility (call it Scenario 2) is that we are all collectively dreaming this will be the case: even in months to come the so-called assets will still be almost worthless pieces of paper. Or, at least, many of them will still be. Then, two possibilities arise from the current Fed bailouts/asset repurchase/fund of banks creation, and so on.

Under Scenario 1, by avoiding marking to market those assets, as financial institutions should currently be doing, the bailouts put off the $1-trillion-worth estimated losses (see Goldman Sachs' own analysis; CNN.com reports 500 billions in losses for mortgages alone) to a later date, hoping that these will in the end be less. In fact, the Fed is betting to be able to "create" Scenario 1, instead of taking the scenarios as exogenously given. The downfall can be avoided if the market (that is, at least someone out there) insists in believing they are worth more: we restore "confidence". By the way, no theoretical model can explain how this change in expectations occurs, other things equal. In other words, Scenario 1 makes sense if and only if we are willing to believe that the Fed has superior forecasting and evaluation powers, so that it can see future gains where the whole set of participants in the financial markets cannot. Is this possible? It is, in the abstract this is quite possible. Is it probable? History and economic theory suggest it is not, still let us assume it is. If we assume it is, that is if we are ready to believe that the Fed is capable NOW to evaluate the prices of assets better than the financial markets can and, by holding them for some time, increase their value in the near future, we should be ready to explain why it was not able to do the same in the PAST, or 2 years from now. Put it differently: if we believe Scenario 1 is what makes the asset swap a good idea, then we must be ready to explain not only why the Fed screwed it up so royally during the last twelve years but why we should not have let the Fed set prices of financial assets during those years! Paradoxes? Indeed, paradoxes they are. More importantly, because bygones are bygones we should also ask: under the maintained assumptions, what prevent us from concluding that, in the future, it will be the new job of the Fed to set the prices of assets and decide which financial institutions should hold them, and which should not? Once again, and for different reasons, we reach the same conclusion as before: IF what the Fed is doing makes sense THEN we might as well consider nationalizing the whole financial sector and let the Fed run it.

Under Scenario 2, however, that’s Japan in the 1990s, instead of its opposite. The Fed intervenes now to avoid for these banks to at least partially acknowledge today the losses that are there and that will never go away. In other words, the Fed intervenes to purely push into the future the day of reckoning, in exactly the same way the Bank and the Government of Japan did after 1990. Western commentators, economists, bankers, and even government officials, very much criticized that choice back then, and invited the Japanese central bank and government to stop acting in the very same way the Fed and the government of the US are acting today. We all pointed out that these actions result in freezing funds, slowing credit growth, keeping alive firms that are dead, and giving rise to a gigantic "liquidity trap", as failing banks were kept afloat by feeding them new credit over and over, credit they never invested or used productively. They simply sat on their reserves, doing nothing and postponing a death that would eventually come. In the meanwhile, economic activity slowed to a dramatic stagnation that lasted almost a decade. How will Scenario 2 end? By slowly bailing out various banks, which will cost all of us a lot of money, during a very long credit market clog that will lead to a very long stagnation. Do you believe that the artificially created liquidity trap that paralyzed Japan for so many years will not happen in the USA? Think again, apparently it is already here, the FT reports.

These are the only scenarios under which the Fed's policy of swapping bad assets for good treasury securities makes sense, so to speak. Right now the only ones ready to believe Scenario 1 are the Wall Street bankers, the Fed and, perhaps, other central banks. To convince others that pieces of paper are actually gold, avoiding the credit clog and the Japan effect, something more than "convincing" has to be done. And that's what the Fed is doing: transferring possession of assets to itself to deflect counterparty risks, which implies buying at fictitious prices the pieces of paper, which implies changing the price of money and Treasuries by changing their supply. Which means, at the end, charging the $600-1,000 billion of real estate market losses to the taxpayer, either directly or indirectly. The bottom line is obvious: there's no new-school change in expectations, but an old-school change in demand and supply of goods and money, and we ALL have to be ready to pay its big price tag: exchange rate depreciation, inflation and a probably longer stagnation or recession. The inflationary cost we are already paying through dollar depreciation and commodity price hike that are translating into CPI inflation. For the long stagnation we will have to wait long.

We don't know you people, but we prefer adjusting relative prices by reducing the value of housing (and of these pieces of paper) soon, rather than increasing the price of everything else and then forfeiting economic growth for a few years to come.