Monday, August 20, 2007

Fed Rate Cut, Bridge over Troubled Water

"On Friday, the Federal Reserve tried to quell this panic by announcing a surprise cut in the discount rate, the rate at which it lends money to banks. It remains to be seen whether the move will do the trick.

The problem, as many observers have noticed, is that the Fed’s move is largely symbolic. It makes more funds available to depository institutions, a k a old-fashioned banks — but old-fashioned banks aren’t where the crisis is centered. And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks.

Now, sometimes symbolic gestures are enough. The Fed’s surprise quarter-point interest rate cut in October 1998, at the height of the crisis caused by the implosion of the hedge fund Long-Term Capital Management, was similarly a case of providing money where it wasn’t needed. Yet it helped restore calm to the markets, by conveying the sense that policy makers were on top of the situation.

Friday’s cut might do the same thing. But if it doesn’t, it’s not clear what comes next.

Whatever happens now, it’s hard to avoid the sense that the growing complexity of our financial system is making it increasingly prone to crises — crises that are beyond the ability of traditional policies to handle. Maybe we’ll make it through this crisis unscathed. But what about the next one, or the one after that?"

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