| Abstract: |
As homeowner equity continues to disappear, there is a growing consensus that
losses on all mortgages will exceed $1 trillion, with financial losses
spreading far beyond real estate. Mortgage rates are spiking and, more
generally, interest rate spreads remain wide, as financial players shun
private debt in the rush to safe Treasury securities. Labor markets continue
to weaken as firms shed jobs, and state tax revenues have plummeted. In March,
the dollar fell to new record lows against the euro and other currencies.
Commodities prices have boomed, fueling inflation and adding to consumer
distress. What's a central bank to do? So far, the Federal Reserve has met or
exceeded the market's anticipations for rate cuts. It has allowed banks to
offer securitized mortgages as collateral against borrowed reserves, and
opened its discount window to a broad range of financial institutions to guard
against future liquidity problems (remember Bear Stearns?). It helped to
formulate a rescue plan for Freddie Mac and Fannie Mae, and Chairman Ben
Bernanke even supported the fiscal stimulus package that will increase the
federal budget deficit—something that is normally anathema to central bankers.
Most importantly, Fed officials have consistently argued that, while they are
carefully monitoring inflation pressures, they will not reverse monetary
easing until the fallout from the subprime crisis is past. Unfortunately, the
policy isn't working--the economy continues to weaken, the financial crisis is
spreading, and inflation is accelerating. The problem is that policymakers do
not recognize the underlying forces driving the crisis, in part because they
operate with an incorrect model of how our economy works. This Policy Note
summarizes that model, offers an alternative view based on Hyman Minsky's
approach, and outlines an alternative framework for policy formation. |