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Bernacke must respond carefully to crisis created by subprime mortgages

After a year and a half of relative calm, Federal Reserve Chairman Ben Bernacke faces his first major challenge with the spread of damage from the subprime mortgage market to credit markets in general. Can he contain the problem and stop it from spreading more broadly?

Former Chairman Alan Greenspan generally received high marks for his handling of the economy during his 18-year tenure, but he is especially remembered for his leadership during a number of crises such as the 23 percent one-day stock market decline in 1987, the problems in financial markets in the Far East, Latin American and Russia, and especially the problems stemming from the end of the stock market dot-com bubble that were exacerbated by the Sept. 11, 2001 terrorist attacks. In all of these crises, Fed policy was successful in limiting the damage.

The current problem has its origins in the Fed's response to the stock market collapse after 2000 and the damage to the economy from terrorism threats after Sept. 11, 2001. Under Greenspan, the Fed aggressively cut interest rates with 13 reductions in the period from early 2001 until mid-2003. The federal funds rate fell from 6.5 percent to a low of 1 percent. This was successful in achieving the immediate goal of stimulating the economy, but an unintended side effect of the low interest rates was the rapid expansion of the real estate market and the growth of the subprime market.

The subprime market was created by institutions that refinanced and often increased the size of mortgages to homeowners of dubious credit worthiness in order to make money. This allowed homeowners to extract new-found equity by using low-interest mortgages with low rates usually not guaranteed for the long-term. When interest rates rose (the federal funds rate is now at 5.25 percent), the interest payments of borrowers also increased dramatically, causing a series of defaults by borrowers and eventually serious problems for lenders and other financial organizations that acquired the subprime mortgages.

The Fed now faces a dilemma in its response to this problem. The seemingly simple answer of lowering interest rates, as advocated by controversial financial guru Jim Kramer, is problematic. First, the Fed continues to be concerned about the problem of possible inflation, which would be worsened by a rate cut. More important, the Fed does not want to bail out the speculators (lenders, hedge funds, and the like) who attempted to take advantage of the subprime market. The way speculators are disciplined in the market is by having their investment fail when they take unwarranted risks. In one sense, the problems in the subprime market should be welcomed as a way of bringing more rationality to the market.

However, the problem the Fed faces is to find a way to have the speculators appropriately disciplined without doing unnecessary damage to the broader economy. If the Fed bails out the speculators, it will create perverse incentives for the future. This is an example of something called the moral hazard problem. A moral hazard occurs when insurance or some other type of guarantee encourages individuals to engage in inefficient behavior. For example, the federal guarantee of deposits in insured financial institutions removes the incentive for depositors to consider the financial health of the institutions where they are considering making deposits.

If the Fed bails out the speculators in the subprime lending area, it will encourage speculators in the future to undertake unwarranted risks. The Fed faced a similar, but less serious dilemma in dealing with the collapse of Long-Term Capital Management in 1998. The $4.6 billion hedge fund, which had two Nobel Prize winners in economics on its board, failed because of unexpected fluctuations in foreign currency markets. In this case, the Fed organized a bailout by various financial organizations with the principals losing much of their investment in order to keep the potential damage from spreading. This obviously sent a mixed message to future speculators by suggesting the Fed might intervene in the case of possible massive failures.

This is the dilemma faced by the Fed today. It is unlikely that there will be any direct intervention by the Fed to help firms in trouble. However, the Fed may be more flexible on the interest rate question. With the stock market having fallen more than 1,000 points below its high and with a number of other indications of possible economic weakness including the problems in the housing sector, the Fed may be more flexible in regard to interest rate cuts. The Fed, the European Central Bank and the central banks have shown their willingness to provide credit to avoid a crisis. To emphasize its commitment, the Fed also cut the discount rate--the rate it charges banks to borrow on a short-time basis.

Unfortunately, there is no policy that can achieve all of the Fed's goals simultaneously: punishing the speculators, keeping the crisis from spreading and standing firm on inflation. If a crisis seems imminent, the Fed's concern about inflation may be put on hold in order to deal with broader concerns about the economy. This will be a test of Bernacke's skill in walking this tightrope.

- J. Fred Giertz is a professor of economics within the University of Illinois' Institute of Government and Public Affairs. He can be reached at (217) 244-4822 or


Morris R. BeschlossMorris R. Beschloss
CIBM Contributor

Despite the slump in housing construction, the U.S. is undergoing a monumental construction boom.

With all attention riveted on the plunge in housing building permits, one of America's greatest commercial and industrial construction booms ever is practically going unnoticed.

This surge is not only offsetting the body blow that the U.S. economy is experiencing from the massive downturn in the five-year housing boom, but the economy is substantially helped by this immense nonresidential rebound.

An unexpected falling vacancy rate is one reason construction activities remain hot. In May alone, nonresidential outlays jumped 2.5 percent with office space spending up 1.6 percent.

This building expansion, however, is much more broad based, as hotels, motels, commercial, industrial and institutional buildings have joined the party.

The swing back to domestic manufacturing is also reflected in new plants and industrial facilities.

Despite this accelerated building boom in the past nine months, the vacancy rate for industrial buildings has remained steady over that period of time.

With both material and skilled workers hard to come by, the slowdown in housing has made the heavy construction industry's welcome turnaround more feasible in a short period.

This commercial and industrial outburst is no short term phenomenon.

Ironically, the five-year housing boom led to the neglect of infrastructural development, as well as not bringing the mechanical contracting of commercial building up to snuff. With employment readily available, the quick shift to commercial and industrial construction has been made possible.

The overall building expansion has become more intensified, with lodging, commercial and manufacturing categories anticipating the greatest acceleration in a decade.

Construction of new plants and manufacturing facilities surged 6.1 percent in May, up 15.5 percent from a year ago.

Like office space, even the long term manufacturing lag has turned around with industrial buildings still retaining last year's low vacancy rate.

At this time, there seems to be no end in sight for this double digit annualized construction increase. Industry researchers expect this boom to last well into next year, with none of the factors comprising this overall market segment anticipating any signs of weakness.

This activity is best exemplified by the month-to-month increase in nonresidential construction starts.

In May, such activity increased at an annualized rate of 4.4 percent over April, while infrastructural spending (highways and bridges, etc.) catapulted 43 percent.

This indicated that the government's $300 billion national infrastructural bill is getting off its haunches in earnest.

The shift of workers from housing to nonresidential construction projects a significant shift between the two pillars of the overall construction industry.

While the number of housing-related construction and contractor-related jobs have declined nationwide by 118,400 over the past year through June, the nonresidential sector has practically absorbed all of this deficit, hiring 108,200 workers. This is the main reason why the pace of the overall construction industry sector is generating little indication of faltering.

That is why the overall U.S. gross domestic product is expected to maintain a growth rate of 2.5 to 2.7 percent this year.

As the slack of downturns in housing and automotive continues to be absorbed by shifts to exports, high technology and re-industrialization, especially in energy and power sub-sectors, the United States' economic engine will be maintaining its acceleration.

- Morris R. Beschloss graduated from the University of Illinois' College of Communications in 1952 and won its first ever Distinguished Alumni Award.

He has been a semi-weekly economic columnist for the Desert Sun for the past several years and writes for the pipe, valve and fittings industry, publishing two newsletters. He can be reached at or (760) 324-8166.

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