Fed Under Fire for Dousing Blaze

12/08/2011 11:35 am EST

Focus: MARKETS

Igor Greenwald

Chief Investment Strategist, MLP Profits

Bloomberg’s tally of the Fed’s generous lending during the crisis is a distraction from the fact that the rescue worked, but probably won’t even be tried the next time, writes MoneyShow.com senior editor Igor Greenwald.

For the second year running recently in rural Obion County in Tennessee, firefighters stood by and watched a home burn to the ground.

The residents hadn’t paid the $75 annual user fee to the nearby city’s fire department.

You might call a policy that lets homes burn callous. I call it in tune with the times.

All emergency responders are vectors of moral hazard. Some of the victims they try to help bear responsibility for their predicament. And even the blameless benefit disproportionately from other people’s taxes.

How can we inculcate proper caution if people don’t suffer life’s maximum consequences? How can we be sure that what looked like a drowning wasn’t in fact a play for a free blanket?

I fear that, as a nation, we’re nearly in Obion County, and the Federal Reserve’s hands will soon be tied like those of the Tennessee firefighters. Sure, the Fed can still toss a credit lifeline to its European colleagues. But its essential role as a lender of last resort is under attack.

Some of that is the Fed’s own fault, and a lot of it is the inevitable result of the deep public cynicism in general and the loathing of bankers in particular.

Whatever the cause, the result is that, under the Frank-Dodd financial reform law, the Fed couldn’t rescue another AIG (AIG). The next big bank to threaten the system will be wound down rather than bailed out. It may or may not pay off its counterparties, who may or may survive as a result.

If former Fed Vice Chairman Donald Kohn is worried, so am I.

The US economy is not at all like a trailer in the middle of nowhere. It’s a complicated and interconnected system with a global reach. A crisis that was allowed to rage out control could cause enormous damage.

So why was a generally reasonable observer like Jon Stewart pretend-choking a kitten last week to express his disgust with the Fed?

It was because he’d read a Bloomberg report casting Fed loans to banks at the height of the last crisis as secret handouts to a favored industry. And why was Bloomberg spinning its scoop that way? In part, because the Fed arrogantly fought its efforts to learn who borrowed what every step of the way.

The Fed also didn’t do enough in 2009 to stop Wall Street’s return to its customary compensation practices. As a result, the $700 billion Troubled Assets Relief Program (TARP) bailout, supported by most Americans the prior fall, quickly turned into a political liability. It was as if a bunch of narcissists crashed their Ferraris, left in a limo and sent government the bill.

So now the Fed is under fire, and it doesn’t like it. On Tuesday, Fed Chairman Ben Bernanke sent to his overseers in Congress a long staff memo rebutting “series of recent articles” without deigning to name Bloomberg. Bloomberg defended its work. Reuters blogger Felix Salmon has a good take on each side’s weaker points, and why the Fed once again didn’t help itself.

Lost in the shuffle is the fact that TARP and the rest of the financial scaffolding erected by the feds to stave off a collapse have been one of the most effective government undertakings of all time—not just because ATMs are still working, but even on a much narrower profit-loss calculus.

The policies weren’t fair in the same sense that any emergency response is “unfair” in marshaling public resources on behalf of those in trouble. But they were unavoidable. And the fact that they’re now so widely despised suggests the firemen will spend the next financial inferno just milling around.

That will be perfectly fair, if only because the Fed’s critics will finally experience the consequences of their demagoguery.

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