Martin Feldstein says we’re in a recession and it could be very, very bad – perhaps the worst since World War II.

We have a liquidity crisis. No trading even in auction market preferred securities, which were previously thought to be as safe as cash (you get a slightly higher rate than a money market in exchange for tying up your cash for say a week). The securities are still asset-backed and AAA-rated, paying interest, but you can’t redeem them because no one is bidding at auction.  This hasn’t ever happened before, and the securities have been around over twenty years.

The Fed can’t do anything about it with monetary policy. The Fed lowers rates, they’re pumping money into banks but banks won’t lend. The spread between the cost of funds to the US government and the rate at which banks lend to each other is widening.

It looks like a liquidity trap, the classic idea of the Fed pushing a string. The Fed lowers rates but banks don’t, they’re afraid to lend and costs stay high. The flip side of the same coin is tha expected value of investing those funds is low. Traditional monetary policy can’t do anything about it.

And fiscal policy is inept for two reasons, first ‘priming the pump’ is generally seen as temporary, as soon as the crisis would pass it would revert to normal. So expectations adjust. Meanwhile, even tax cutting won’t help for the same reason lowering rates doesn’t help — if the expected rate of return on investments is close to zero, the rate of tax doesn’t affect the investment decision.

So what’s a federal reserve to do? Exactly what the Fed did in extending credit to Bear Stearns.

At first I thought it was crazy, desperation, the world coming to an end. Then I realized it was the classic Milton Friedman prescription, dumping money from a helicopter. When the banks won’t lend you have to go around the banks. The normal barrier to this is that it’s politically difficult, you get opposition from the groups that don’t get the money drop. So instead you need specific situations for intervention, a la the Fed bailing out Bear Stearns, to inject direct liquidity into the markets.

Will this help? This one instance isn’t enough to make a difference in the economy, but the Fed probably does have the theory right at least.

A bit of ironic speculation, though. Since we’re headed into a recession, while a Democrat will be elected President we won’t see higher taxes (and here I’m betting against the prediction markets which are forecasting a tax increase). Democrat believers in countercyclical fiscal policy (a la Keynes) won’t raise taxes during recession. And for all their criticisms of the Bush budget deficits (criticisms which are both fair and on point!) they will themselves run substantial deficits. Why? Because I ascribe enough rationality for them to do so… They won’r raise taxes and rein in deficits while the economy is contracting.

Anyway, that’s my take on the current economy and what it means going forward for policy.

But make no mistake, we are in recession and it could be a bad one.

(Some links above via Greg Mankiw and Tyler Cowen.)