The Magazine

The Credit Crisis of 2008

As was the case a century ago, it's good to have a J.P. Morgan when you need one.

Mar 31, 2008, Vol. 13, No. 28 • By IRWIN M. STELZER
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Paulson now finds that the intervention game he has learned to play might be more than the one-inning affair he had hoped. In for a penny, in for a pound, as British bankers say--although lately they have been willing to be in for neither. Democrats believe that government should insure mortgages that have been written down to current value (Barney Frank), send money to the states for the relief of homeowners facing foreclosure (Hillary Clinton), or provide those home-owners with help of a vague and unspecified sort (Barack Obama). Now that the Fed has decided that investment banks and brokers are too intimately interconnected with all the other players in the financial system to be allowed to fail--to the traditional "too big to fail" add "too interconnected to fail"--the taxpayer has become a key player. Not a new role: After all, the savings and loan crisis of the 1980s and 1990s came to an end only when the government tossed about $125 billion of taxpayer money at the problem.

Future researchers are also going to have to sort out the relationship between the Fed's monetary policy, the rate of inflation, the value of the dollar, the trade balance, and a host of other economic drivers. The March 18 cut in the so-called Fed funds rate, lowering it to 2.25 percent (a negative interest rate, when inflation is factored in) was only the latest in a three-percentage point cut since September of last year. As every economist knows, or thought he did, such a reduction in short-term rates will bring long-term rates, set in the market, down with them. Except that long-term rates, which are most relevant to businesses seeking to expand and consumers considering purchasing a car or a house, remain stubbornly high, diluting the stimulating effect of the Fed's actions. Many lenders believe that the Fed is playing too fast and loose with the money supply, and that the resultant inflation will drive down the value of the dollars with which they will be repaid. So they raise the price of their money--the interest rate that they charge for its use.

It seems that the inflation-wary have guessed right: Prices of food, energy, and just about everything that is not an electronic gadget have risen, and with them inflationary expectations. All exacerbated by the path of the dollar, which has been spiraling down. Despite singing that old tune, "American interests are served by a strong dollar," the administration is humming under its breath something like "down and down it goes, in a spin, and we are loving the spin it's in." A cheap dollar makes our goods less expensive abroad, stimulating exports and thus adding significant growth to a slowing economy. True, the decline in the value of the dollars that oil producers are getting for their crude causes them to raise the price in order to protect their ability to purchase arms and baubles in the world's poshest shops. They also worry that the imported laborers who do the work that their native populations find offensive are restive: The dollars these workers send home to their families are buying less and less. The last thing the rulers of Arab nations want is an uprising by foreign workers who in many cases outnumber the native population.

True, too, that the falling dollar has the Chinese very nervous. "What concerns me now is the continuous depreciation of the dollar," says Prime Minister Wen Jiabao. No wonder. The vaults of his country's central bank are overflowing with stacks of financially deteriorating green paper adorned with pictures of American presidents. But Bernanke has had to choose: shore up the financial system by pumping dollars into it in such amounts that the banks will start lending again or fight inflation by keeping interest rates high. It's an increasingly tough call, as the dissent by 2 of the 12 members of the Fed's monetary policy committee to the last rate cut demonstrates. Bernanke is betting that the economic slowdown will lower inflationary pressures, and that if he has uncorked the inflation genie he will be able to bottle it up again by raising interest rates once the current credit crisis has run its course.