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  • The Week on the Hill

Interesting times, are they not? We have a presidential election as momentous as any in living memory. The United States might soon elect its first black leader -- and in just this past week, really for the first time, with the Jeremiah Wright affair and Barack Obama's remarkable speech, the campaign has turned to look unflinchingly at race in America.

Meanwhile, still weirdly disconnected from the presidential contest, things go from bad to worse in the economy. The Federal Reserve has cut interest rates almost to nothing, is busy bailing out the banking system, and is making up new rules as it goes along. Observers of the economy have sweaty palms and glassy stares.

The startling disconnect between politics and the financial crisis may be a blessing in disguise. With the political system so distracted, and the Bush administration content to run out the clock, the Federal Reserve can take charge without being second-guessed. In the end, legislation may be needed to soften the impact of the economic slowdown, and it will certainly be needed later to lessen the chances of a repetition. But it would be good if some thought went into the details first, and a degree of shelter from the agitation of the campaigns must help. For now, the tools available to the Fed, such as they are, are the right ones.

In the past week the Fed has cut its benchmark interest rate by another three-quarters of a point, to just over 2 percent. Over the weekend, after frantic negotiations, it supervised the sale of Bear Stearns, a stricken investment bank, to J.P. Morgan Chase. The Fed had to sweeten the deal with $30 billion of loans secured against Bear's smelliest assets. This means that the Fed -- that is, the taxpayer -- has shouldered a large part of the risk. (J.P. Morgan, meanwhile, gets the bank for a little over $200 million, compared with a recently reported book value of $80 billion. Little wonder its share price surged.)

In addition, the Fed has widened the class of assets against which it is willing to lend; it now includes mortgage-backed securities. And in yet another innovation, the Fed has announced that firms like Bear Stearns will in the future be able to borrow directly from its discount window -- a privilege previously limited to deposit-taking banks.

In all of this, the Fed's goal is simple: to maintain the flow of credit in the economy. A recession (commonly defined as two successive quarters of declining output) has most likely already started, but the more the flow of credit now slows, the longer and deeper this downturn will prove to be. An outright collapse of the credit system -- which is the scenario that the imminent bankruptcy of Bear Stearns evoked at the weekend -- could conceivably lead to years of economic stagnation and decline, such as Japan suffered in the 1990s and the United States last faced during the Great Depression.

The Fed's problem is that the squeeze on the credit system at the moment is very strong. The crux is the subprime mortgage meltdown. A toxic combination of loans -- trillions of dollars' worth -- that should never have been offered in the first place, together with the bundling of these debts into black-box tradable securities, has spread losses of still-uncertain size all around the financial system.

As house prices continue to fall, the losses will grow. Those losses, in turn, eat away at banks' capital -- which forces banks to curb their lending. The scale -- and the opacity of the losses -- make banks reluctant even to lend to one another, not knowing whether they can expect to be repaid. This tightens the credit squeeze still further. Meanwhile, the demand for credit is falling too, for a variety of mutually reinforcing reasons -- households' desire to reduce their debts in a time of uncertainty, the collapse of turnover in the housing market (and, with that, the fall in demand for goods and services associated with moving), and so on. A vicious circle has kicked in: The housing market sinks, losses on mortgage-backed securities worsen, credit tightens further, consumers retrench, the housing market sinks ...

Lower interest rates are the remedy of first resort. In ordinary times they increase both the demand for and the supply of credit. They especially buoy the housing market. (Cheap loans in the past few years helped create the housing boom in the first place.) But the lower limit on interest rates is zero, and it is fast approaching. Beyond that, the Fed is not yet helpless, but it must resort to literally printing money -- to "monetizing" the budget deficit -- which is another innovation it would doubtless prefer to avoid. A big risk in going there is what might happen to the dollar. The Fed does not want the recent (helpful) decline in the currency to accelerate into a full-blown dollar crisis.

If banks are too scared to lend and consumers too scared to borrow regardless of interest rates, even the most aggressive easing of monetary policy might fail to push the economy out of recession. That is why, separately from the push to lower interest rates, the Fed is struggling so hard to maintain structural confidence in the financial system -- by keeping Bear Stearns in business and by promising to give banks (and now, for the first time, many nonbanks) the assurance of access to short-term loans they are no longer willing to extend to each other.

Where does it all end? If the Fed could be granted one wish, it would be that house prices start to bottom out. That would begin to put a floor under losses on mortgage-backed securities, and help to restore banks' confidence in one another. Its biggest fear, conversely, is that house prices fall further and faster. A particular risk in that case is that many more borrowers would find they owed more than their house is worth, so that it would make sense for them to default on their mortgage. (Most mortgages are nonrecourse loans, meaning that in case of default the lender gets the house and has no further claim.) If mortgage defaults catch on in a big way, causing a flood of foreclosures and forced sales, it is hard to say where the floor for house prices might be -- and the losses for lenders could dwarf current estimates.

Congress is weighing measures sponsored by Rep. Barney Frank, D-Mass., and Sen. Christopher Dodd, D-Conn., to interrupt this process. The idea is that in exchange for voluntarily writing down a mortgage by some fraction, qualifying lenders would get a guarantee from the Federal Housing Administration on the new balance.

It is a smart idea, in that lenders have to take a hit (the write-down) in return for their subsidy (which is what the guarantee really is). It would also help to stabilize the housing market, because it would reduce the number of foreclosures and it would give lenders more confidence. On the other hand, it rewards people who borrowed more than they could afford. Their mortgages get reduced for free, with the cost shared between lenders and the government. That is a bad message to send. It takes two parties to create a stupid mortgage. Also, the guarantees would pose a new, unknown, and potentially very large risk to taxpayers. If house prices keep falling anyway, the FHA could end up with huge losses.

America's tax regime for mortgage borrowers is already among the most generous in the world. It helped to inflate the housing bubble in the first place. In addressing this crisis, a remedy that increases taxpayer support for reckless borrowing is not, on the face of it, good policy. My instinct would be not to do this -- not just yet, anyway. But this judgment depends on what happens next. If the situation continues to deteriorate, the Frank-Dodd scheme might be the lesser evil. Will things, in fact, continue to deteriorate? The truth is, nobody knows.

In one way, the alarm is still running ahead of the facts. Even now, most forecasters are expecting only a brief and mild recession. Unemployment has risen, but only slightly, and it is still low by international standards. Growth in the rest of the world is still quite strong, and that will help to support the American economy -- especially with the dollar so cheap, as this will give a boost to exports. If banks and other intermediaries can rebuild their capital with new equity investment (and here is an idea: cut dividends and wages, too), then their lending would take that much less of a hit.

But if house prices keep falling, and subprime losses keep mounting, I would not bet on a happy outcome. Just a few months ago, the Fed was saying that the subprime situation was under control. This week, it was running around as though the economy were hanging by a thread. Events thus far have proved the gloomiest pessimists correct.