Bernanke Plays a High-Risk Game

"The hedge fund boys get in a little trouble and now you want the nanny state to come to the rescue?" is how economist Dean Baker, director of the Center for Economic and Policy Research, good-naturedly critiqued my recent call for the Federal Reserve to cut interest rates. Yet it's not just millionaire hedge fund managers taking a beating right now. Whenever the Dow tanks—as it's doing again today—America's broad investor class suffers, too.

Of course, it's not the Fed's role to protect investors—whether their money is socked away in hedge funds or 401(k)'s—from 10 percent market corrections. But one thing the Fed is supposed to do is prevent financial panic from dragging the economy into recession. Economist and CNBC host Larry Kudlow points out in a must-read blog post today that the huge drop in yields on supersafe three-month treasury bills—they're currently trading at a full percentage point lower than last week—is particularly ominous amid this spreading credit crunch. What does this all mean? Let me quote Kudlow at length:

"The entire banking system has turned completely risk averse and is fleeing into the safest haven possible. It is fear. It is hoarding cash. It is a mountainous tremor that has seized financial markets. ... The first order of business for the Fed is to protect the banking system. Credit deflation is a nasty virus. It requires a strong antibiotic. The trick is to not only keep the banking system afloat but to prevent the credit virus from bringing down the economy."

Kudlow thinks the Fed should keep adding new money into the banking system and lower its target rate, which currently may be a point and half too high at 5.25 percent.

"It should float the federal funds rate and let reserve and money-market forces determine the right rate level as it injects new liquidity into the system. A T-bill rate around 3.5 percent suggests a fed funds target rate of perhaps 3.75 percent, or somewhere thereabouts. Put simply, Ben Bernanke and company should let the money market set the new target rate. Their job is to create enough new cash to stabilize and accommodate the fear-based rush of liquidity demands."

It's time for the Fed to stop the fear and end the panic that are threatening an economy that still possesses solid fundamentals. As economist Robert Brusca puts it: "People do not stand in front of a skidding car thinking it will stop in time. Even if they think it will stop, they run now and ask questions later. That is where markets are right now. They are skidding out of control, and the Fed is betting they will stop in time while taking only slow and small steps toward safety."