The Duke of Hazard

Ben Bernanke, hearing the cries of powerful investors during an election year, cut both the Fed Funds rate and the Discount rate 75 basis points. Apparently, if investors want the Fed to bail them out, they only need throw a tantrum. It is bad for parents to give into spoiled children. It is equally bad for the Fed to give into spoiled investors.

Here are the plain facts. 1) The Fed created an asset bubble by lowering rates too far, keeping them too low for too long and raising them too slowly.

2) Markets which are permitted to function properly subscribe to Einstein's Theory. For every action there is an equal and opposite reaction. If we have a period of easy money driving home prices and growth to outrageous levels, there must be a corresponding correction.

Investors don't want that to happen. They want a one way street of ever higher asset prices with no correction and they expect the Fed to give it to them. If the Fed continues to act accordingly, we will have the much feared stagflation.

Remember how we had stagflation in the 1970s. The Fed would not take steps to combat inflation because it did not want to hamper growth. What happened was that inflation kept trending higher and growth slowed anyway because no one could afford anything. Paul Volcker came in and, counterintuitively, raised rates during a period of slow growth. Once he broke the back of inflation, interest rates came down and economic growth began a trend of a robust, but sustainable pace.

Traders an investors should not only be rewarded when they take risk and bet right, the also need to be allowed to take their lumps when they bet wrong or get in over their heads. This helps to maintain orderly markets over the long run. Bailing out investors and traders when they get into trouble only encourages bad behavior and makes future similar market disruptions more likely and, possibly, more severe. This is the infamous moral hazard.