Rate cuts won't cure ailing market

By Jon Markman

In a country whose populist heroes are kick-ass rebels Jack Bauer, Jason Bourne and Bart Simpson, it is perhaps only fitting that our latest would-be real-world savior is an economist and banker whose monkish beard makes him look almost countercultural.

Unlike his fictional counterparts who always save the day with a snappy remark or a chop to the throat, Federal Reserve chief Ben Bernanke is working from a terrible script that is doomed. He seems like such a nice man that it's a pity he could go down in history as the first one-term Fed chief in decades, not to mention the accidental steward of one of the world economic system's darkest periods.

It's going to take me a few moments to explain, so bear with me. Here's the problem: Last Friday, Bernanke earned a round of applause from the media by bowing to White House and Wall Street pressure and slashing the rate that the Fed charges the nation's least-creditworthy commercial banks for loans from the public till. He also allowed these sketchy banks to put up their worst loans as collateral and radically lengthened the time that they are permitted to hold onto these borrowings from the standard single day to a month or more.

In doing so, the common belief is that Bernanke provided a much-needed shot of adrenaline to the financial system. Yet this medical metaphor, which seems so apt, really misses the point. What the Fed really did was perform an imperfect version of the Heimlich maneuver on the credit markets, dislodging a blockage in one section of its windpipe only to allow the chicken bone to embed itself more firmly elsewhere.

The Fed is now about to embark on a long series of interest-rate cuts in the face of a global economic slowdown, but it has no proof that cheaper money can, by itself, unwind the worldwide credit crunch.

It could work if Bernanke and other U.S. financial officials are able to persuade the biggest institutional investors here and overseas that it will work. Or it could end up lighting an inflationary brush fire that combines with a recession to create the perfect storm of unending investor pain.

All I can tell you is that the last time this was tried in a pre-contraction environment, it failed miserably. From January 2001 to June 2003, the federal funds rate fell from 6.5% to 1% even as the S&P 500 ($INX) fell by 26%, from 1,320 to 976. The lesson: An earnings collapse beats low interest rates every time.

Bring on the pain

Some veteran market observers have remarked that if the Fed had not cut the rate it charges at its "discount window" to 5.75% from 6.25%, providing the illusion of more liquidity, the Dow Jones Industrial Average ($INDU) could have crashed 1,000 points on Friday or Monday.

Well, this may sound harsh, but in the fullness of time we may pine for the crash. Because instead of a short-term crisis that would have wiped out a few overleveraged hedge funds, brokerages and individuals -- causing terrible pain to innocents as well, no doubt -- we may instead wind up with a debt debacle that stretches on for years and years and harms many more.

The plain fact of the matter is that every few decades since the dawn of paper money, long periods of outstanding economic growth have led complacent noblemen, companies, governments and private citizens to borrow large sums amid boundless optimism that that they will pay the principal and interest back on time. Inevitably, reality has caught up with these sponges at the worst possible moment, and they have been forced to surrender their collateral and pride.

• Talk back: Time to bring back debtors prison?

In ancient times, creditors were often permitted to torture debtors, and up to the mid-1800s debtors prison was the destination for irresponsible borrowers.

Exploding packages

Today the situation is quite different in a fascinating way. Blame for bad risk-taking is so spread out, and collateral so ephemeral, it's hard to know whom to punish and what to seize. Even as recently as the 1980s, thrifts took real balance-sheet risk by providing mortgages to individuals.

There were loan officers whose jobs were on the line if they made bad loans, and regulators scrutinized the process. In the last housing bust, several S&L chiefs went to jail for their roles in fraud and mismanagement.

Oh, for the good old days -- a much simpler time before financial engineers figured out, with evil genius, how to distribute risk more widely. In the mid-2000s, when money became super-cheap under former Fed Chairman Alan Greenspan, S&L officers were replaced by mortgage "originators" who were paid merely on volume and were not graded by the after-sale performance of their loans.

Continued: A global game of hot potato

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