What's So Scary About A Recession?

In 25 years looking at the US economy and global markets, I have never seen such swift action from the Fed and the government, theoretically designed to avert or ease a looming recession. For example, the Fed's 75 bp one-day cut was the largest in its history and the fiscal stimulus bill was approved by Congress in record time. Everything is being done in a great big hurry. Why? And what further conclusions may be drawn from such action?

Part of the reason lies in the people: Mr. Bernanke is an academic who made a career out of blaming the Great Depression on the Fed, and Mr. Bush has never met a tax cut he didn't like. In addition, most of Congress is up for re-election this year and sending cash to voters is as close to hog heaven as a politician will ever get in his/her career.

But from a statistical standpoint, at least, the overall economy hasn't yet weakened appreciably. The medicine being administered seems way out of proportion to the illness. At 3.50% Fed funds are already at the level of late 2001, when the economy was 3/4 of the way out of the recession and much below current inflation, which is running at 5.7% annualized for the three months ended in December.

Fed Funds Target Rate

Because of the Great Depression, American financial and political institutions are terrified of the spectre of deflation. Until perhaps a decade ago, a replay of such a catastrophe was deemed impossible because of the Keynesian social state erected in the intervening decades. But two developments since the 1990's have apparently changed this view:

a) Japan became a glaring example of a modern welfare state suffering from two decades of deflation and zero growth due to the bursting of share and real estate bubbles.

b) Beginning with the Reagan Revolution, the US radically transformed its economy and is now focused on free markets, laissez-faire and individualism, instead of government intervention and social cohesion. Its structure is currently closer to that of the 1920's than at any other time since the end of WWII.

In other words, I think Washington and Wall Street now recognize the danger of a deflationary implosion, even if they don't come out and say it openly, and even if they caused it themselves by unchecked reliance on Adam Smith's invisible hand. This would certainly explain the swiftness and the size of the "insurance policy" currently being taken out by the Fed and the government (i.e. watch what they do, not what they say).

It looks like Bush, Bernanke, Paulson and Co. are scared to death and the recent plunge in global stock markets is giving them the willies. After all, those that live by the sword (the market) are in constant fear of being killed by it.