Yesterday, the Federal Reserve made a shocking announcement: Bear Stearns, one of the most venerable banks in the United States, was bailed out at a fraction of its value by J. P. Morgan Chase. Only five days ago Bear Stearns, founded in 1923 and a commercial bank that had weathered the Great Depression and numerous recessions, was selling for $70 a share. Now JP Morgan will buy its stock for only $2 a share, as if it were bankrupt.
Now Bear Stearns and Eliot Spitzer have something in common: A dramatic fall from grace in a matter of days. And they both happened in the same week.
But the impact of the Bear Stearns crash is far more significant than the demise of a popular albeit arrogant governor.
The bailout of Bear Stearns underlines the depth of the financial crisis facing the United States as a result of the never-ending real estate debacle and the subsequent credit crunch. Like Eliot Spitzer, Bear Stearns was an aggressive and arrogant participant in the mortgage lending business, and now it has paid a devastating price.
Not surprisingly, the global reaction has been swift. Stocks across the world, beginning in Asia, dropped sharply, the dollar took another tumble, and gold rocketed up to $1,020 an ounce. Is there no end to this madness?
The Fed has panicked, as they have done numerous times in past crises, and their solution is always the same — inject billions of dollars in more liquidity, aggressively cut short-term interest rates, and assist in the bailing out of troubled institutions.
Will it work again? History is on the side of the Federal Reserve and central banking, which intervened during the 1987 crash, resolved the S&L crisis in the late 1980s, survived the Asian currency crisis in 1997, bailed out Long Term Capital in 1998, and helped the economy recover from the shocking 9/11terrorist attacks.
But this time the bailout has been more difficult because the Fed under Alan Greenspan was so reckless in its “easy money” policies of 2001-04, cutting rates to an irresponsible 1%, and failing to regulate the banking mortgage business properly. Many economists, including Yale’s Robert Shiller and this author, warned investors and Wall Street that this “easy money” policy was setting a dangerous precedent, and would have terrible consequences. Austrian economics (the economics of Ludwig von Mises and Friedrich Hayek) teaches us that there is no free lunch in monetary policy. The easy-credit policies of the Fed generated a structural inflationary imbalance and “asset bubbles” in real estate and many income investments. And what goes up must come down.
We are now going through the cleansing process of a deflation and recession in real estate, stocks and industrial production. (Consumer spending, which has held up well, is never a very good leading indicator.)
The Fed’s bailout mentality has meant a sharp sell off in the dollar and rising oil, gold, and commodity prices. Last week for the first time in history the Swiss franc hit $1, and gold jumped over the magical $1,000 figure. Oil is already at $110 a barrel. Paul Volcker, former Fed chairman, predicted a dollar crisis several years ago, and now we are in it.
If the Fed was smart, it would stop cutting interest rates below the “natural rate.” Cutting interest rates below 3% will do little to alleviate the credit crunch, and can only exacerbate the dollar crisis and cause oil and gold prices to rise further.
But I’m in a minority in this regard, and the Fed is likely to cut rates on Tuesday.
What to do? Investors would be wise to play it conservative at this time, and invest in well-diversified mutual funds, and to maintain a hedge and insurance policy in cash as well as gold and silver, either in the form so coins, or exchange traded funds in gold and silver bullion.