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Purely hypothetical

Dean Baker:

In his testimony before Congressional today, Ben Bernanke reportedly made an effort to sooth uneasy financial markets. For this he was widely applauded by the business press. But is it the Fed's job to be soothing financial markets?

Let's throw out a purely hypothetical scenario. Imagine that the bad news on new home sales, mortgage applications, durable goods orders, and productivity actually translates into an economy that is about go into a recession.

Now let's suppose that the market has two types of investors. The first type are the high rollers. They move in and out of financial assets on a moment's notice. Let's call them "hedge funds." The second type are naive investors. They put money into the stock market at regular intervals and let it sit. We'll call them middle class 401(k) investors.

Okay, now in our hypothetical scenario, because the economy is genuinely facing serious problems, the market is likely to be heading downward in the months ahead. Our hedge fund investors will likely begin to recognize this fact and dump their stock. On the other hand, our middle class 401(k) investors are likely to keep putting new money into the market.

Suppose that Mr. Bernanke recognized that the economy is facing trouble and told Congress that the future looks bleak. The markets would presumably crash, because both the hedge funds and the middle class 401(k) investors would dump their stock. Everyone takes a hit, but the pain would be shared between the hedge funds and the middle class 401(k) investors.

Now, let's suppose that Mr. Bernanke recognizes bad times ahead, but thinks that it is best to try to calm the financial markets, so he tells Congress that the economy is just fine. While this could be sufficient to assuage the middle class 401(k) investors, the assurances may not be sufficient to calm the hedge fund investors. Suppose they offload their stock over the next few weeks.

In this case, Bernanke's soothing words would have the effect of keeping the market high while the hedge fund investors offloaded their holdings. The big losers would end up being the middle class 401(k) investors who keep buying into a sinking market.

In this purely hypothetical scenario, it would not be good for Bernanke to soothe financial markets, unless the goal is to redistribute wealth from middle class 401(k) investors to hedge funds. While this scenario may bear no relationship to the actual situation, it is not always true that the Fed should be trying to stabilize financial markets. The press could ask some questions along these lines, instead of just assuming that stable financial markets are always good.

By fnord12 | March 1, 2007, 5:36 PM | Liberal Outrage