"Where is the government?"

That’s a question I’ve been getting from some readers recently. Notwithstanding this afternoon’s dramatic rise in stocks, the first 2.5 days of the week made it look as if the world was coming to an end. After Bernanke lowered interest rates, stocks fell dramatically anyway, before climbing back a bit Tuesday afternoon. It was Tuesday morning that a reader asked, why isn’t the government doing more?

To which my reply was: what is the government going to do? Bernanke just made an emergency rate cut, the largest in years. Bush and the Democrats are busy outbidding each other on a “stimulus” package. What else can they do? The reader suggested the government offer to bailout failed banks. But the government already backs GSE debt I responded. If the shit really hits the fan, if house prices decline 30% nationally as so many have predicted (most recently Merrill’s chief economist), you can bet Fannie and Freddie will fail. That alone could cost more than the S&L scandal. How many more failed banks is the government supposed to back? And which ones? And how do you make that decision now before any have failed?

Politicians are short-run thinkers always in ass-covering mode. If the economy implodes they’ll want to be able to say they at least tried to do something. Nevermind that acting too soon will tie their hands when action is more desperately required later on.

Indeed, all this action strikes me as ludicrous. Wall Street yells loud enough in their ears and Congress and the Fed decide they have to act. But are their actions helping? The rate cuts I can understand: even though aggressive easing threatens an unhealthy unwind of dollar-denominated securities, you can plausibly argue that with bank balance sheets shrinking, deflation is the real threat. [Remember, in a monetary system that relies on fractional reserve banking, money is largely created as banks make loans. As their balance sheets shrink, so does their lending capacity.....as the supply of credit goes, so goes the supply of money].

What I don’t understand is the “stimulus plan.” Today the Wall Street Journal reported that Ds and Rs are both looking to expand it. Before the latest market hiccup, the Democrats were pushing for rebate checks for all Americans whereas Republicans were talking about tax breaks for individuals and incentives for business investment. Now they’re working on a bill that combines BOTH ideas.

The Senate Banking Committee Chairman thinks the government should buy deeply distressed mortgage assets. I’m all for buying distressed mortgages, but that activity is best left to expert investors.

It’s good to see candidates fumble in this mess because many are betraying utter ignorance of basic economic principles. Hillary and John Edwards argue we should be “freezing interest rates” on ARMs for 5-7 years. Have they considered the interest rate penalty everyone else will face? Interest rates are prices. Fixing them is tantamount to fixing prices. Go ask the Venezuelans what price-fixing does to economic activity.

The answer is it stops it. Our economic problems can either be allowed to work themselves out, or allowed to fester for years.

There are no good choices right now. The government’s true failure was allowing banks to create this systemic crisis in the first place. You can tell from this strident rant of a post that I favor laissez-faire, supply-side economics. Yet moderation is called for. Just as banks have risk management departments to check the activities of rogue traders, the government should have some basic regulatory structure to prevent systemic crises. Ad hoc of course.

All we would have needed in this latest crisis were regulations limiting subprime lending practices, and perhaps rules about rating agencies getting paid by the underwriters of the bonds they’re rating. That’s all. Simple stuff. Hardly socialist.

What bothers me, at the end of the day, is that Congress and the President appear to be panicking even BEFORE we’ve entered recession. If ever a steady hand was called for, it is now. Too bad we haven’t elected any.

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