Fed's not-so-magic act

Paul Krugman wrote his NYT column right before the Bear Stearns mess, but the concerns about Fed policy ring true - perhaps even more so. Krugman points out that there's only so much the nation's central bank can do to stabilize banks and credit markets, and that so far the traditional tools - mainly lowering interest rates - haven't done much good. That's because banks are simply not willing to take on any more risk, which means they're not about to sign off on loans for businesses looking to expand or consumers looking to buy houses.

So now the Fed is following one of the options suggested in [Ben Bernanke's] 2004 paper, which was about things to do when conventional monetary policy isn’t getting any traction. Instead of following its usual practice of buying only safe U.S. government debt, the Fed announced this week that it would put $400 billion — almost half its available funds — into other stuff, including bonds backed by, yes, home mortgages. The hope is that this will stabilize markets and end the panic. Officially, the Fed won’t be buying mortgage-backed securities outright: it’s only accepting them as collateral in return for loans. But it’s definitely taking on some mortgage risk. Is this, to some extent, a bailout for banks? Yes.

To Krugman's knowledge, no advanced-country’s central bank has ever exposed itself to this much risk — and yet $400 billion is not much money when considering the scope of the problem. “I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care,” he writes. “At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what it’s doing to an angry public.”