US Treasury and the Fed: too close for comfort?

Economic historians must see the actions of today's Federal Reserve as strange.

"Very, very unusual," says Allen Sinai, chief economist of Decision Economics, an economic consulting firm. "Unprecedented … uncharted."

The nation's central bank has joined with the United States Treasury in a host of measures this year aimed at stopping the economic slump and financial crunch from plunging the economy into a depression. The Fed's bold activism is apparently based on the view of its chairman, Ben Bernanke, that the Great Depression was caused by a credit freeze – plus a determination not to let it happen again. At Princeton University, where he had taught for years, Mr. Bernanke's research centered on that economically desperate era of the 1930s.

Last Tuesday, for example, the Fed and the Treasury announced $800 billion in new lending programs to help jolt the economy into a more vigorous life. The Fed said it would purchase up to $600 billion in debt issued by or backed by housing-related government-sponsored enterprises, such as Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Home Loan Banks. It will also back up as much as $200 billion in securities tied to student loans, car loans, credit-card debt, and small-business loans.

A major goal is to lower the interest rate on mortgages and make mortgage money more available.

"Hooray," exults Ed Yardeni, an economic consultant and president of Yardeni Research in Great Neck, N.Y. "A home run."

He sees the action as needed to deal with the major drop in housing prices that is behind the economic crisis in large degree.

As Mr. Yardeni sees it, the Fed and the Treasury have been playing "Whack-A-Mole" this year, striking at a series of liquidity-related crises, as a number of financial institutions faced going bankrupt and Washington came to their rescue with injections of funds and other measures. The latest was the huge multibillion dollar boost given Citigroup last Monday.

To Murray Weidenbaum, President Reagan's top economic adviser in 1981 and '82, the new Fed has had to take "a more activist stance than the old Fed," considering the serious economic threat facing the nation. He finds it "innovative" to see Chairman Bernanke and Treasury Secretary Henry Paulson working so closely together to deal with the crisis.

At the same time, he worries somewhat about the Fed's historic independence from the president and his administration, a system set up by Congress in 1913 to assure that politicians do not weaken the soundness of the dollar by inordinate influence on the Fed.

To veteran economist Anna Schwartz, however, the Fed's current policy of lowering interest rates and rapidly expanding the nation's liquidity is a mistake.

"I would like to see the Fed tighten monetary policy," she says in a phone interview from her office in New York at the National Bureau of Economic Research.

Ms. Schwartz is famous among economists as coauthor with Milton Friedman of a book blaming the Fed for the Great Depression by allowing the nation's money supply, that is, cash and deposits in banks, to decline drastically. She and Mr. Friedman are what economists call "monetarists" for their assumption that trends in the Fed's supply of money to the economy lead to cyclical ups and downs.

Schwartz criticizes the Fed's leaders for "handing out money so freely … squandering their funds" and not giving evidence that they are concerned with their prime responsibility, price stability.

As for the danger of deflation – steadily falling prices – she dismisses that as "ridiculous" considering the massive injection of new money into the economy in recent months. She's also astonished that Bernanke has been pushing fiscal stimulus, that is, extra federal spending and tax cuts to boost economic activity. Usually Fed chairmen try to stay out of the fiscal business of Congress.

Now there are reports that President-elect Obama will ask for a stimulus package as big as $700 billion over the next two years.

To economist David Levy, the new measures, including those of the Fed, are essential to offset a dramatic reversal in consumer-debt creation (credit cards, car loans, home mortgages, etc.) as consumers fear for their financial safety. In 2004, consumers added $1 trillion to their debts, $2.4 trillion over the next two years, and $880 billion in 2007. This year consumers are probably repaying some debts, says the chairman of the Jerome Levy Forecasting Center in Mt. Kisco, N.Y.

"We are increasing public debt to replace private debt that is vanishing," he says. "A capitalist economy cannot run without debt creation."

Neither Levy nor Mr. Sinai are optimistic about the economy. It could be the worst recession since the 1930s, says Sinai, but not a depression.