The Federal Reserve, Now Bailing Out Politicians

Rick Newman
December 1, 2011

The bank bailouts in 2008 and 2009 were controversial because wealthy bankers seemed like the last people who needed help. Now, the Federal Reserve and other central banks are rescuing one group held in even lower regard than bankers: politicians.

Financial markets cheered recently when the Fed and five other central banks took action to ease a credit crunch in Europe's financial sector. Stocks soared, as investors expressed relief that somebody, finally, seemed able to do something decisive to improve the situation in Europe.

Yet the central bank maneuvers, meant to ease the ability of foreign banks to trade their currencies for dollars, do nothing to address the fundamental debt problem bedeviling Europe. Euro-zone nations such as Greece, Italy and Spain remain overwhelmed with debt, with no agreement in sight on how they can fix their finances and make their economies more competitive. Central banks temporarily easing the strain may even make the required fixes less likely, since it gives politicians wiggle room to stall on reforms needed to rein in profligate spending.

The bank bailouts in 2008 and 2009 stabilized the U.S. financial system, but they also added to the "moral hazard" that contributed to the problem in the first place. By making it clear that the government wouldn't let big banks fail, the bailouts signaled that bankers can get away with risky moves, since the feds will always provide a safety net. The Federal Reserve and its compatriots in Europe and Japan are now basically creating political moral hazard, by letting elected officials know that if they can't get the job done, the central banks will step in to prevent a full-blown disaster. It's an invitation to further recklessness that politicians don't need.

Europe's debt problems, like those in the United States, are complicated but not beyond fixing. It's generally known what overdrawn countries need to do. The International Monetary Fund has laid out a detailed set of spending cuts, tax hikes and other reforms Greece must enforce in order to continue receiving bailout money. Italy and Spain haven't asked for a bailout yet—and there's nowhere near enough money available if they do—but they must still appease investors who buy their bonds, by liberalizing work rules, unclogging the pipeline for new businesses and growing faster. If they don't, the interest rates they must pay to borrow will keep rising, until debt-servicing costs overwhelm the whole economy.

The problem is that enacting those kinds of reforms disrupts inbred institutions and requires voters to make sacrifices, for the apparent benefit of financial overlords in other counties. So politicians dither as long as possible, and try until the last second to pass the cost of reforms to bondholders, or anybody else.

"Policy makers believe that if there is some magic elixir, governments will have the breathing room to clean themselves up," says currency expert Axel Merk, president of Merk Investments in Palo Alto, California. "However, policy makers have proven that the moment the pressure abates, the willingness to push through tough reforms evaporates."

The European Central Bank, in fact, has resisted the kind of aggressive intervention practiced in the United States by the Federal Reserve, out of concern that it will let Europe's political leaders off the hook and pre-empt the need to fix corrupt or broken economies. It still hasn't embarked on a huge, Fed-style bond-buying program, but investors now clearly think the ECB—prodded, perhaps, by the Fed—is getting off the sidelines, ready to prime Europe's economy. That's good in the short-term for stock markets, but if politicians get a reprieve, all the fundamental problems will continue to hamstring the European economy.

America's debt problem is easier to solve, since it only takes one legislative body to pass a plan (rather than the 17 in the euro zone), and one executive to sign it into law. But Congress has obviously decided it doesn't need to solve anything, evidenced most recently by the debt "supercommittee" that disbanded after accomplishing nothing at all. Fed Chairman Ben Bernanke has pleaded with Congress to come up with a plan to pay down the debt, before it becomes an intensifying problem characterized by rising interest rates, tightening credit and a sudden crunch that is sure to be felt by taxpayers. But since those pains aren't yet present, Congress has ignored Bernanke.

It was Congress in 2008 that authorized the spending of roughly $700 billion to bail out the banks, then passed another big stimulus bill in 2009 to help lessen the impact of what turned out to be a near-depression. Though those measures were controversial, Congress was doing its job. But since then, Congress has backed away from stimulus or job-creation measures, even though the economy is in precarious shape and the jobless rate remains sky-high. Nor has it come up with a debt-reduction plan that would reassure investors or guarantee that the nation's credit rating won't fall any further. The Fed has become the lone economic stimulator, as well as the backstop for the whole economy, through "quantitative easing" and other programs meant to boost the value of stocks, force interest rates down, and keep credit flowing.

The Fed is running out of tricks, however. And besides, it's not the Fed's job to oversee the government's spending, taxing and borrowing. That's up to Congress and the president.

The Fed and its equivalent in other countries can delay some of the pain—for awhile—but eventually, politicians will need to do the job they were elected to do. Giving them an excuse to do nothing, until there's no other choice, could make the job that much harder when they finally get around to it.