Wednesday, September 17, 2008

In Response To Worsening Credit Predicament, The Federal Reserve Stays One Course, Changes Another

Fed Holds Rates Amid Turmoil, Financial Times
Fed in $85 Billion Rescue of Insurer Near Failure, New York Times
Stocks Dive in Early Trading Despite Fed’s A.I.G. Bailout, New York Times

The Federal Reserve made two major announcements on Tuesday.

The first of these announcements was that the Federal Reserve would not lower the benchmark interest rate, which has held steady at 2% for some time as part of the Federal Reserve's efforts to battle inflation. While, early in the day on Tuesday, U.S. investors had seemed hopeful that the Federal Reserve would choose to lower interest rates, the decision to leave the rates as they were was seen by many as an indication that a Federal bailout of insurance giant AIG was forthcoming.

Indeed, later in the day Tuesday the Federal Reserve and the U.S. Treasury Department announced a massive, $85 billion bailout of AIG. This investment in the failing AIG by the federal government, aimed at preventing a worldwide financial panic, was not only an unprecedented move, it also directly contradicted the Federal Reserve's earlier "line in the sand" proclamation that that accompanied its refusal to bail out Lehman Brothers.

While the Federal Reserve, the Treasury Department, and much of the U.S. and worldwide financial community felt that the AIG bailout was necessary, it has not come without controversy. Many American politicians have called the bail out excessive and have heightened their calls for an aggressive investigation into the regulatory failures which may have contributed to the development of the worsening financial crisis, both in the United States and throughout the global marketplace.

1. Was the Federal Reserve correct in leaving the interest rates unchanged? Should the fight against inflation take priority over the need for greater liquidity in the marketplace?
2. Is the government bailout of AIG appropriate? What, if any, alternatives did the U.S. government have to a bailout of this scale? What would have been the consequences of the collapse of AIG?

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