Beware of Unintended Consequences

According to the Wall Street Journal, "the Federal Reserve has joined with four other major central banks to announce a series of measures designed to inject added cash into global money markets in hopes of thawing a credit freeze that threatens their economies."

Unfortunately, there's also the risk that today's news could have unwelcome consequences, including the following:

• Investors could become more defensive. If credit conditions and market prices, especially for the shares of financial firms, don't remain exceptionally buoyant in the wake of these developments, momentum investors, highly-leveraged traders, and buy-and-hold types who had been complacently sticking with fully invested positions up until now might start thinking about paring back holdings. If others take notice, a trickle of selling could easily turn into a flood.
• Confidence might be jolted rather than bolstered. Instead of making everyone feel reassured, the dramatic policy response could, in fact, convince many investors, corporate executives, consumers that conditions are far worse than everybody had been led to believe. That could trigger self-defeating behavior (e.g., dramatic cuts in 2008 budgets or a reduction in counterparty credit lines), which would have contractionary effects and would likely compound an already widespread and growing unwillingness to take risks.
• Central banks' role could be questioned. Any sign that today's measures haven't done what was seemingly intended could lead growing numbers of individuals to question the role that central banks play in the economy and why they are given so much leeway or authority in regard to monetary policy and regulatory matters. Some might wonder, like presidential candidate Ron Paul, why we need institutions like this in the first place.