Has Ben Bernanke announced his true allegiance?

The Federal Reserve's surprise move sent the stock market into a tizzy glee. Shades of the Maestro?

Published August 17, 2007 9:45PM (EDT)

If you want to see some real geeky action, stick your head into a bar full of drunken economists, holler the words "Greenspan put," and settle back to watch the fireworks.

The Greenspan put refers to the mildly conspiratorial theory that Alan Greenspan could always be counted upon to protect stock traders from their own self-destructive impulses by hastening to cut the federal funds rate whenever the stock market seemed in danger of tanking. Bloomberg's consistently excellent Carolyn Baum defines the concept and provides some of the available evidence:

A put option gives the buyer the right to sell a security, commodity, index or futures contract at a specific price by a specific date. Buying a put protects the holder against a decline in prices.

The "Greenspan put" entered the lexicon after several stock-market rescue efforts: Greenspan cut the overnight federal funds rate in 1995 following the Mexican peso crisis and Orange County, California, blowup and again in 1998 in response to the near-collapse of hedge fund Long-Term Capital Management. Investors came to refer to, and rely on, the Greenspan put as an implicit guarantee that the Fed would cut rates if things got too dicey in the stock market, which had become the national pastime in the late 1990s.

The drawback to the "Greenspan put" is that it qualifies as what economists like to call a "moral hazard." It gives traders an unwarranted sense of security that encourages them to take unjustifiable risks with their money, because they know that the Fed will always bail them out.

But market observers disagree as to whether the Greenspan put ever really existed. There's a difference, they say, between lowering rates to help an economy avoid or grow out of a recession, and lowering rates just to nurture a bearish stock market back to life. And there's no good evidence, some will argue, that Greenspan was guilty of the latter sin.

But Greenspan is gone. Ben Bernanke is in the hot seat now. And this morning, the Fed surprised the market by announcing a cut in its discount rate. Not to be confused with the much more important federal funds rate, which governs the interest rate applied to overnight transfers of cash between banks, the discount rate refers to the rate at which the Fed will loan money directly to banks. Much of the commentary this morning suggests that the significance of the move is largely symbolic. Banks haven't been using the "discount window" very often.

But symbolism carries great weight in financial markets that are experiencing the kind of frantic volatility we have become accustomed to in the last few weeks. At Portfolio Magazine, Naked Capitalism's Yves Smith, filling in for the vacationing Felix Salmon, declares that Bernanke has shown his colors with the bold move -- the "Greenspan put" is alive and well. The stock market certainly enjoyed the news, shooting up instantaneously and keeping its gains all day long.

How the World Works declines to take a position on whether the "Bernanke put" should now be part of the market-punditocracy lexicon. But I think that the giddy glee that sent share prices soaring back up on Friday is misplaced. For months and months, the Fed's extraordinarily modulated pronouncements on the state of the economy have downplayed, first, the housing bust's impact on the overall economy, and second, the subprime mortgage lending collapse. We have been told that these factors might constitute a "drag" on the economy, but that the damage was unlikely to spread more widely.

By its actions Friday morning, the Fed implicitly admitted that it was wrong. The housing bust and subprime collapse are endangering the health of the overall economy. Why the stock market sees this as encouragement is a bit baffling to me.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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