There are various steps of intervention that the government can take when it is trying to react to a crisis. The first step is to merely signal that the climate is undesirable and that it is looking into options. The next step is to change monetary policy to be more accommodating. The next is to make small scale interventions by bringing together private parties and getting them to work things out with implicit government support. The next is to make direct purchases/injections on a small scale level to show it will be willing to commit real money. All of those steps are seen as much about managing expectations and “restoring confidence” as they are about actual impact on supply or demand. The final step is when the government makes whole scale guarantees and massive direct purchases on such a scale that it becomes the major player.

The reason why so many economists are freaked out has nothing to do with the raw numbers about unemployment or whatever other metric you want to use, it is that since WWII the government has been able to manage the economy primarily with the “restoring confidence” steps, and only one time had to do the final step on a tiny (relative to GDP) scale when the S&L crisis hit. Now the government is on the last step in amounts that are over 50% of the GDP and things are still cratering. In fact the entire financial system is still on the brink of collapse and will go down unless they ignore reality, which is why they are talking about suspending accounting rules. The problem is that ignoring reality in one market just makes it pop up somewhere else. The more that the government ignores the root cause of the banking crisis (the fact that it’s extremely insolvent) the more that interventions will just cause yields to rise on government debt and its linked chains.

When the government effectively backed all conforming mortgages by saying that Fannie/Freddie were as good as gold, mortgage rates plunged, but then quickly rose when that guarantee came into question. So the government (the Fed) stepped in and started buying massive amounts of mortgages in order to keep rates down, and they plunged again. It was so effective that people were talking about how the government should just guarantee that mortgages go for between 4.0% and 4.5% in order to get things flowing again. The only problem is that the more that the government intervenes, the more illiquid it makes that market and so it requires more and more intervention. Obviously the Fed hasn’t been able to keep it as high as it should be since rates are soaring again. I would be very surprised if the rates don’t rise back to where they were in the early parts of the crisis (around 6%) and if the government buys enough to keep them low, then government bonds will just show the difference.

We are now seeing historical interventions on a monthly basis, and they are affecting things for less and less time. The government is very close to losing control of the levers (globally as well, the currency market action is insane) and I pray that we will wake up and start getting crash teams in place (increased unemployment benefits, food stamps, utilities help, support to the states so more don’t go bankrupt, etc.) than arguing about resodding the national mall or marginal tax rates. Both parties need to give it a rest and do the important things first that will be necessary to keep basic function…then they can argue about how best to rebound. Trying to save everything will just result in catastrophe.