Wednesday, September 19, 2007

The Daily 2¢ - Enter Darth Inflator

“Everything that has transpired has done so according to my design. I wonder if your feelings on this matter are clear, Lord Inflator.”

It should be obvious to all today that the Federal Reserve and Ben Bernanke actually intend on attempting to “prevent” the “housing correction” from intensifying and impacting the broader economy.

This seems to foretell a strategy that, although may appear perfectly justified from the standpoint of an observer who generally believes the housing correction will be mostly contained, may actually be the worst possible action should things continue to worsen.

I believe the 50 basis point rate reduction is simply another, albeit significant, example of the Fed simply underestimating the nature of the housing crisis and its potential for long term harm to the economy.

By taking this action now, the Fed is clearly attempting to relieve the recent fear and anxiety of the markets in an effort to restore order in an economy that they generally believe “seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”

But if the housing decline is a much more fundamental process then the Fed anticipates, taking many more years to play out, is it really sensible for them to attempt to “forestall” the effects now, especially given that hardly any real effects have been felt?

I think it would have been wiser to allow the housing recession to play out longer, free from intrusive actions, with the confidence that, although the efficiency of the markets will result in creative destruction of wealth and households, the speed of the correction would be swift and certain leaving the economy better prepared to expand out of the aftermath.

By taking these actions, and likely more like them in the future, the Fed may cause the housing correction to be draw out, with multiple failures and false bottoms, causing a slow bleed that could last for many years to come.

It’s an ironic twist that in an era when Japan is desperately attempting to adopt a modern American economic model, we may well be, in fact, adopting Japans model of the past.