Trapped: Why the Federal Reserve Can't Save the Economy

Last Updated Nov 4, 2010 2:28 PM EDT

Ben Bernanke increasingly resembles a mime trapped in a box -- no matter how hard he pushes, the damned thing just keeps closing in on him. Just like the economy.

The Federal Reserve Chairman hopes to extricate us from that predicament by purchasing another $600 billion in Treasury bonds. Here's the best-case scenario, as laid out today by Bernanke:

[L]ower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
In your dreams, Ben. The reason home sales are slow isn't because mortgage rates are too high -- it's because most people are too scared and too poor (and perhaps too smart) to take the plunge on real estate, no matter how affordable.

It's also because, no matter how low interest rates go, borrowing remain prohibitively expensive. As bank analyst Chris Whalen of Institutional Risk Analytics has reported, fees charged by big lenders and the GSEs now run 4 to 5 points for new loans, compared with 1 point during the housing boom. That greatly increases the cost of the loan, deterring prospective home buyers (Refinancing costs remains similarly onerous.)

It's also not at all clear that easing borrowing terms for business will do much to boost investment. Big companies are already sitting on the order of $2 trillion in cash, and they're not spending it. Smaller enterprises, which generate most new jobs in the U.S., are the ones hurting for dough, and they're struggling to get a loan.

Will a short-term, moderate dose of quantitative easing boost consumer spending, as Bernanke claims? Doubtful. Americans are unlikely to open their pocketbooks simply because their 401(k) returns are marginally higher than a year ago. They'll also assume, correctly, that whatever gains they make in the stock market could suddenly evaporate once the Fed ends its bond binge.

Besides, as Charles Hugh Smith explains, whatever wealth is generated in the financial markets is likely to be offset by the rising price of commodities, which drives up the cost of food, energy and other necessities. That's because pumping money into the economy depresses the value of the dollar:

It may be the ultimate -- and ultimately tragic -- irony: While the Fed's policy is supposed to help the economy by encouraging more borrowing, the actual effect is to raise prices for companies and consumers alike, and to squeeze the very corporate profits that have been driving stocks higher.
As for hopes that monetary expansion will finally boost bank lending, I wouldn't count on that, either. Banks remain hugely exposed to the fragile housing sector and to government debt. It's also a lot harder for lenders to make a buck, especially as costs soar for servicing mortgages and handling foreclosures. And anyway, whatever profits Wall Street firms report are largely illusory, given the enormous, if unrecognized, losses that continue to contaminate their books. Someday, they're going to need all that capital, as top bank officials well understand. They're in no position to liquify the economy even if they wanted to.

Of course, Bernanke is under enormous pressure to do something (anything). Under former Fed chief Alan Greenspan, Bernanke and other officials at the agency helped inflate an $8 trillion housing bubble, and did nothing to contain the damage when it finally popped. So the Fed's latest intervention was to be expected.

But if monetary policy can serve as a spark, it's not a magic wand. Whatever solutions are out there, they won't be found tinkering on the supply side of the equation -- the problem here is one of insufficient demand. Short of a massive shot of fiscal stimulus -- a dead letter given the midterm results -- the economy is likely to stay on its present course: going nowhere.

Image from Wikimedia Commons, CC 2.0
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    Alain Sherter covers business and economic affairs for CBSNews.com.