It's an interesting time to be a macroeconomist

What with the financial markets imploding and all. The blog postings on what's going on in financial markets and at the Fed are coming fast and furious. For a sampling, check out

- Mark Thoma on the latest analysis by Tim Duy. Bottom line: despite the fact that the effective federal funds rate has been well below the Fed's official target of 5.25 percent for several days now, it's not at all clear that the Fed is going to change its target at the September meeting. The Fed has been making huge injections of liquidity into financial markets on a temporary basis (via repurchase agreements); once the dust settles in financial markets the liquidity will quickly disappear and the federal funds rate will return to target.

- William Poole, President of the St. Louis Fed, explaining why he sees no need for a rate cut right now. He does not see (yet) any spillover from the financial market crisis to consumption or business spending.

- The always scary Nouriel Roubini, by contrast, does see an impact on consumption spending. Retail sales at U.S. chain stores are down in August, and WalMart and Home Depot have warned of low earnings this year.

Also, you can now clearly see the subprime carnage spreading to near prime and prime mortgage markets as there is a generalized credit crunch in mortgage markets (more on this in a forthcoming blog). This and the worsening housing recession means greater default rates among homeowners ahead, lower home prices ahead, lower home equity withdrawal and a weakening of an already fragile US consumer. The macro consequences of falling home prices for the first time since the Great Depression have not been fully considered by the consensus soft landing analysts. The severity of this housing recession, its impact on other sectors of the economy and on a weakened consumer, and its financial markets fallout will be much significant than the consensus believes. The risks of a US hard landing are meaningfully rising.

Plus now we find that and new home construction is at its lowest level in a decade. The Fed is operating under the "Greenspan doctrine," which states that it should intervene only when the financial market meltdown affects real economic activity. All well and good, but if economic activity begins to weaken it will face another dilemma. The housing construction and consumer spending booms that have fueled the U.S. economy for the last four or five years were unsustainable. A correction is inevitable and desirable - at some point, we have to stop building McMansions in big empty fields 50 miles out from where the jobs are; at some point, people have to start saving for their retirement or at least stop building up huge balances on their credit cards and home equity loans. Precipitous action to lower interest rates, to the extent that it would prop up home construction and consumer spending, would delay the necessary adjustment process. One hopes that the reduction in spending on those fronts will be offset by increases elsewhere - exports have been strong lately, but you'd have to have an awfully large increase in export growth to counteract even a modest decline in consumption spending. If manna doesn't fall from the heavens to bail the economy out, it wouldn't surprise me if the Fed stayed pat for awhile anyway to let the real economy "work its way out" of its imbalances.

This is exactly the type of situation that calls for an activist, old-style Keynesian fiscal policy. Suppose the Federal government had a list of infrastructure projects lined up with funding pre-approved contingent on the announcement of an economic emergency. The economy shows signs of weakening, the Fed declines to reduce interest rates, so the President declares an emergency and releases $50 billion or so in funds to repair roads, bridges, schools, and so on. Manna drops not from heaven but from a wise and prudent government. Economy is stabilized.