Just how powerless is the Fed, hypothetically?

Ilargi: If I were to name my favorite writers on finance, Henry C K Liu would be right up there in the top 5. His articles are long, but that’s because he shares so much information. Kudos also go to the little known Asia Times, a truly high quality publication with gusto, which publishes much of his writings.

That said, I seamlessly move into an area where I tend to hypothetically disagree with what Liu says in the piece featured below, and where Stoneleigh and I kind of disagree. Yes, that happens.

The title of Henry Liu’s January 26 2008 article, Fed helpless in its own crisis, implies something that I’m hypothetically, and strictly for entertainment purposes, not necessarily comfortable with, namely that the current financial crisis happens despite the Fed, which can do nothing but stand by helplessly, hands in their sparse hair, implementing last minute desperate measures that are doomed to fail.

Yet, it was this same Fed that lowered interest rates to 1% from 6.5% some five years ago, and whose chairman, a certain Greenspan, subsequently went public, waxing poetic about the too numerous to mention benefits of homeownership in the US, as well as the great innovations in the derivatives markets that would spread the risk of investment so broadly across the spectrum that risk would in reality disappear altogether. Hypothetically.

Then, the Fed, the one and only organization out there that gets all relevant economic numbers on its desks everyday, all the time, supposedly sat back and watched the mayhem come to fruition, for years, without changing or correcting a thing. And now we are to believe they didn’t know what happened right before their eyes, that they are more clueless than a whole slew of writers and economists who have warned for a long time about what was going on?

I don't think it's overly presumptuous to hypothetically question that presumption, if only because accepting it at face value would mean that the arguably most powerful financial organization in the world is run by hundreds, if not thousands, of highly paid alleged experts, who, all of them combined, have less insight in the field of economics than some writers have all by themselves.

Maybe, hypothetically, and strictly for entertainment purposes, we could consider the possibility that the Fed isn’t so helpless after all, that their focus is simply not on keeping the US economy going smooth as can be and steady as she goes. For if that were their goal, they certainly are doing a much worse job than you and I would. So maybe, hypothetically, and strictly for entertainment purposes, we can try seeing events unfold with a view to what things would look like if we hypothetically presume that they are going exactly the way the Fed planned. Strictly for entertainment purposes.


Fed helpless in its own crisis

After months of denial to soothe a nervous market, the Federal Reserve, the US central bank, finally started to take increasingly desperate steps to try to inject more liquidity into distressed financial institutions to revive and stabilize credit markets that have been roiled by turmoil since August 2007 and to prevent the home mortgage credit crisis from infesting the whole economy.

Yet more liquidity appears to be a counterproductive response to a credit crisis that has been caused by years of excess liquidity. A liquidity crisis is merely a symptom of the current financial malaise. The real disease is mounting insolvency resulting from excessive debt for which adding liquidity can only postpone the day of reckoning towards a bigger problem but cannot cure. Further, the market is stalled by a liquidity crunch, but the economy is plagued with excess liquidity. What the Fed appears to be doing is to try to save the market at the expense of the economy by adding more liquidity.

The Federal Reserve has at its disposal three tools of monetary policy: open market operations to keep Fed Funds rate on target, the discount rate and bank reserve requirements. The Board of Governors of the Federal Reserve System is responsible for setting the discount rate at which banks can borrow directly from the Fed and for setting bank reserve requirements. The Federal Open Market Committee (FOMC) is responsible for setting the Fed Funds rate target and for conducting open market operations to keep it within target. Interest rates affects the cost of money and the bank reserve requirements affect the size of the money supply. [..]

On Monday, January 21, a week before the scheduled FOMC meeting, global equities plunged as investor concerns over the economic outlook and financial market turbulence snowballed into a sweeping sell-off. Tumbling Asian shares - which continued to fall early on Tuesday - led European stock markets into their biggest one-day fall since the 9/11 terrorist attacks of 2001 as the prospect of a US recession and further fall-out from credit market turmoil prompted near panic among investors, forcing them to rush to the safety of government bonds.

About $490 billion was wiped off the market value of Europe's FTSE Eurofirst 300 index and $148 billion from the FTSE 100 index in London, which suffered its biggest points slide since it was formed in 1983. Germany's Xetra Dax slumped 7.2% to 6,790.19 and France's CAC-40 fell 6.8% to 4,744.45, its worst one-day percentage point fall since September 11, 2001. The price collapse was driven by general negative sentiments and not, so far as was apparent at the time, by any one identifiable event.