Why the Fed Won't Bail Out the Stock Market

On Tuesday, July 10, 2007, the Chairman of the Federal Reserve Board, Ben Bernanke, made a speech in which he said very little about the Fed’s current intentions concerning inflation and interest rates. The Dow Jones Industrial Average fell 148 points, the Nasdaq stock market fell 30 points and the S&P 500 Index fell 21 points. What happened? Why would the markets fall when the guy said basically nothing about what the markets were interested in?

You might not think the term “moral hazard” has anything to do with the Federal Reserve Board. It evokes images from the 1950s of nice girls being duped by sly, sweet-talking boys. But moral hazard is one of the principal dynamics in today’s financial markets.

Moral hazard, in the parlance of economists, means that a person doesn’t bear all of the negative consequences of his or her conduct. Moral hazards are often considered undesirable because they lead people to take greater risks than they would rationally take if they had to bear the full cost of their behavior.

For example, taxicab drivers in Manhattan are notorious for not stopping and exchanging license, registration and insurance information after a minor, fender-bender type accident. They’d rather keep driving and collecting fares than get bogged down for a half an hour with paperwork. Because they don’t always bear the full consequences of minor accidents, they may not drive as carefully as other people.

Moral hazard is part of the world of government regulation. When the banking system swooned during the Great Depression, the federal government instituted a system of insuring customer deposits in order to restore confidence in banks. However, the government faced the problem of banks luring customers in with the promise of government insurance, and then making risky, but potentially profitable, loans. If the loans paid off, the banks would win big. If the loans defaulted and the banks couldn’t repay their depositors, the Federal Deposit Insurance Corporation bore the cost of making the depositors whole. In order to prevent banks from taking undue risks, the federal government imposed stringent regulations on the banks’ activities, and hired a staff of examiners to periodically review the banks’ books and records, and see if they were making loans the way cabbies drive in Manhattan.

In the early 1980’s, federal regulators removed many of the limitations on the loans that savings and loan associations (a type of bank) could make. In essence, they allowed the savings and loans to venture into many arenas where they had little or no experience. The result was a debacle. Many savings and loans secured depositors’ money with promises of high interest rates in government insured accounts, and made risky loans that promised big rewards. But they proved incapable of dealing with the risks of those loans. Numerous savings and loans collapsed, and the federal government was left barefoot and pregnant to clean up the mess. The subsequent savings and loan bailout, in the early 1990’s, cost each American taxpayer something in the range of $3,000. Moral hazard can be expensive.

It’s important to understand that government policy and actions create moral hazard. When the government assumes the risks and costs of something, it wittingly or unwittingly encourages people in the private sector to take greater risks (because those people won’t bear all of the consequences of those risks). This applies to the Federal Reserve, as well as other government agencies.

In the 1990’s, the Fed acquired a reputation for being highly skillful at managing the economy. Since the mid-1990’s, the economy has had only mild downswings, but has enjoyed healthy upswings. In spite of a variety of major stresses—the stock market bubble and bust of the late 1990’s and early 2000’s, the real estate bubble and bust of the mid-2000’s, rising energy prices, a flood of subprime and other mortgage defaults, enormous federal deficits, gigantic U.S. trade deficits, and a falling U.S. dollar—the U.S. economy has merrily rolled along, for the most part. Unemployment is quite low under the circumstances. Consumer spending never seems to have a bad day. And inflation largely seems to be moderate—okay, not when it comes to energy prices, but otherwise it hasn’t been out of control.

This picture of ever-sunny days encourages investors to take greater risks. If you believe that the Fed has somehow, through increased knowledge, skill, technology, magic or alchemy, learned how to prevent bad economic consequences, then you’d expect that taking greater risks gives you the potential for larger rewards without much chance of losing money. You’d pay higher price-earnings multiples for stocks, expect lower interest rates on bonds, and buy real estate using the looniest of interest only or option ARM mortgages. Why? Because you'd think that nothing will ever go wrong, and if it does, Uncle Fed will bail you out.

Chairman Bernanke has learned from experience to keep his cards close to his vest. So his intentions are not crystal clear. But it’s fair to say that his principal regulatory goal is to contain inflation. He correctly sees inflation has the greatest long term threat to the health of the economy (see our blog at http://blogger.uncleleosden.com/2007/06/why-federal-reserve-matters.html), and will keep interest rates where they are, or even raise them, in order to tamp down any inflationary brush fires.

The stock market doesn’t want to believe this. It’s gotten used to the idea that the Fed will make all boo-boos go away. These days, there are downdrafts in the financial markets. The subprime and other mortgage markets keep slipping down the slippery slope. The private equity deal market is stumbling from resistance by bond buyers to more “covenant-lite” bonds (which are bonds with terms highly favorable to the private equity firms, and not terribly protective of bondholders). Foreign holders of the U.S. dollar, like the Chinese central bank, are easing towards greater diversification of their foreign currency exposures (which means downward pressure on the dollar). Economic statistics exert a push-me, pull-you effect on the stock market, resulting in breathless short term upswings and stomach-churning short term downswings. The picture on corporate earnings will be revealed in the next couple of weeks, but sunshine isn’t necessarily in the forecast.

Given the ambiguous outlook, the stock market wants the Fed to lower interest rates (or, at least, signal that it will lower them in the near future). Chairman Bernanke didn’t give the market that message today. Reading between the lines, one gets the impression that Chairman Bernanke, and the rest of the Fed, are struggling with the moral hazard created by the Fed’s success of the last decade. People invest aggressively, thinking the Fed will save the day if clouds roll in. But if the Fed bails out the stock market, it will only encourage investors to take more risk and eventually need bigger bailouts.

Ultimately, the Fed doesn’t have the power or ability to save people from investment errors. It can, and will, endeavor to fight inflation. If it can keep inflation contained, it will also try to maintain solid economic growth. But it won’t provide a bailout for the stock markets.

For yourself, focus on long term diversified investing. Don’t speculate in the short term with the expectation that the Fed will support the value of your investments. It won’t.

For more about our practical investment guidelines, please go to Uncle Leo’s Den at www.uncleleosdencom/Step11InvGuidelines.html.

Strange News: the flying lawn chair--a new way to have weekend fun. http://www.cnn.com/2007/US/07/10/flying.lawn.chair.ap/index.html.