Second, an observation: In the time I’ve been avoiding this blog and the news, nothing has changed. Legislators and economists are still arguing over fiscal stimulus, the financial regulation bill looks pretty much the same as it did a month ago (or two months ago, for that matter), investors are still worried about European debt, and Afghanistan is still a complete mess. I used to think the world would pass me by if I stopped paying attention for a few weeks, but I’ve come to realize that real change is rare—and the bulk of what we spend our time worrying about is the same things over and over.  

Take the weak economic recovery, for instance. About three weeks ago, Nobel Prize-winner Paul Krugman and Chicago financial economist Raghuram Rajan got into a debate over when the Fed should raise interest rates. By the time I returned to Trading 8s, I thought I was too late to weigh in on this debate. I should have known better. The focus has shifted to fiscal policy, but the debate goes on.

A couple days ago, Krugman vented his frustration with this debate in his New York Times column, followed by a blog post remembering all the times we’ve rehashed this debate over the last year and a half—and how the deficit hawks were wrong every time. Fellow economists Dean Baker and Mark Thoma second his motion and show how the debate has little to do with economics and almost everything to do with politics. I encourage you to read all three of those brief but accurate commentaries.

You really know that the debate hasn’t changed when you’ve already said everything you want to say. In my case, that means republishing what I wrote seven months ago:

The Federal Reserve just can’t catch a break.

Back in 2001, the Fed caught hell for allowing the dot-com bubble to escalate so steeply. For the following two years, it found itself between inflation hawks who worried about historic low interest rates and deflation hawks who thought high unemployment was a harbinger of Japan-style depression.

After giving the Fed a breather for a few years, observers jumped on them in 2007 for ignoring warnings about predatory lending, in March 2008 for fostering moral hazard with the Bear Stearns deal, in September 2008 for crashing the economy by letting Lehman Brothers fail, and in the rest of 2008 for lowering interest rates too slowly before and during the crisis. In 2009, they were sandwiched between economists who wanted more aggressive, “unconventional” monetary policy and those who cautioned against loading up the Fed’s balance sheet with dangerous assets.

Now they are in the middle of inflation hawks like Washington Post columnist David Ignatius and U.S. Senator Charles Grassley, weak-recovery worrywarts like Fed Chair Ben Bernanke and Nobel Prize-winning economist Paul Krugman, and bubble predictors like LSE economist Willem Buiter and NYU economist Nouriel “Dr. Doom” Roubini.

It makes the 1990s seem quaint, no?

This latest bind, like most of the Fed’s troubles, was predictable and preventable…but not by them.

Severe inflation is a laughable prediction to anyone with the faintest understanding of financial crises (pick up a copy of This Time Is Different by Kenneth Rogoff and Carmen Reinhart for a superb summary), but another bubble is not out of the question. It was, after all, in the wake of the dot-com crash that the housing bubble formed.

The most prominent such warning came from Roubini in the pages of the Financial Times a few weeks ago. He, like Buiter, worries that low interest rates will fuel asset speculation. Roubini sees it manifesting in the foreign exchange market, Buiter in developing nations like China.

Their fears are not misplaced. If consumers are willing to spend and workers can demand higher wages, low interest rates can fuel inflation. But when the economy is depressed, low interest rates may encourage investment by those with the means to borrow.

The paradox is, while Buiter and Roubini are right to worry about speculation, Bernanke and Krugman are also right to worry about high unemployment and slow growth. Low interest rates are a necessary evil until the economy becomes much stronger.

What most observers have failed to recognize is that economists predicted precisely this Catch-22 in early 2009 when they recommended that the government nationalize failing banks. Because they failed to fix the financial sector, toxic assets continue to weigh down the recovery to this day. From the beginning, the Fed has been forced to help banks in the only way it can—through monetary policy—when the best solution would have been for the FDIC and Treasury to nationalize them and strip them of their toxic assets like Buiter, Krugman, and Roubini all suggested.

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Back in 2001, the Fed caught hell for allowing the dot-com bubble to escalate so steeply. For the following two years, it found itself between inflation hawks who worried about historic low interest rates and deflation hawks who thought high unemployment was a harbinger of Japan-style depression.

After giving the Fed a breather for a few years, observers jumped on them in 2007 for ignoring warnings about predatory lending, in March 2008 for fostering moral hazard with the Bear Stearns deal, in September 2008 for crashing the economy by letting Lehman Brothers fail, and in the rest of 2008 for lowering interest rates too slowly before and during the crisis. In 2009, they were sandwiched between economists who wanted more aggressive, “unconventional” monetary policy and those who cautioned against loading up the Fed’s balance sheet with dangerous assets.  

Now they are in the middle of inflation hawks like Washington Post columnist David Ignatius and U.S. Senator Charles Grassley, weak-recovery worrywarts like Fed Chair Ben Bernanke and Nobel Prize-winning economist Paul Krugman, and bubble predictors like LSE economist Willem Buiter and NYU economist Nouriel “Dr. Doom” Roubini.

It makes the 1990s seem quaint, no?

This latest bind, like most of the Fed’s troubles, was predictable and preventable…but not by them.

Severe inflation is a laughable prediction to anyone with the faintest understanding of financial crises (pick up a copy of This Time Is Different by Kenneth Rogoff and Carmen Reinhart for a superb summary), but another bubble is not out of the question. It was, after all, in the wake of the dot-com crash that the housing bubble formed.

The most prominent such warning came from Roubini in the pages of the Financial Times a few weeks ago. He, like Buiter, worries that low interest rates will fuel asset speculation. Roubini sees it manifesting in the foreign exchange market, Buiter in developing nations like China.

Their fears are not misplaced. If consumers are willing to spend and workers can demand higher wages, low interest rates can fuel inflation. But when the economy is depressed, low interest rates may encourage investment by those with the means to borrow.

The paradox is, while Buiter and Roubini are right to worry about speculation, Bernanke and Krugman are also right to worry about high unemployment and slow growth. Low interest rates are a necessary evil until the economy becomes much stronger.

What most observers have failed to recognize is that economists predicted precisely this Catch-22 in early 2009 when they recommended that the government nationalize failing banks. Because they failed to fix the financial sector, toxic assets continue to weigh down the recovery to this day. From the beginning, the Fed has been forced to help banks in the only way it can—through monetary policy—when the best solution would have been for the FDIC and Treasury to nationalize them and strip them of their toxic assets like Buiter, Krugman, and Roubini all suggested.

In my column in today’s South Florida Sun-Sentinel, I address how to prevent this misstep in the future.

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Coming from one of the world’s leading experts on econometric predicting, Hamilton’s improved mood says more than all of Jim Cramer’s rants put together. He cites increased activity in the auto industry, an uptick in home sales, a slight increase in consumption, increased expectations for third quarter sales in several large industries, and significant recovery in the Aruoba-Diebold-Scotti Business Conditions Index. (Full disclosure: Frank Diebold, one of the authors of the index, is a good friend and former teacher of mine. He is also a world-class econometrician, but I have not asked him for his outlook at present.) Indeed, those are most of the important measures of whether individuals and firms are starting to spend again, which is precisely what is needed to end a recession.

Hamilton is not taking a stand on whether the recession is over and cautions that the end of “Cash for Clunkers” could prick an artificial high in auto sales, personal income still hasn’t risen, and unemployment shows no signs of falling. But the latter two usually follow on the heels of the other indicators he cites, and the positives seem to greatly outweigh the negatives. So why isn’t Hamilton’s emoticon smiling?

A lot of it has to do with the “shape” of the recession, as economists have explained it to the public of late. A “V-shaped” recession, like we used to have in the 1960s and ‘70s, implies a sudden end to the recession and a sharp return to growth. A “U-shaped” recession, like we had earlier this decade, means growth will be slow and unemployment will continue to rise for awhile even after the recession technically ends. Because consumers are still “deleveraging”—that is, because they have more debt than twentieth-century consumers had—most economists predict the latter, as spending won’t return full-force until they pay off their debt. If nothing else, such an expectation warrants a neutral face instead of a smiling face. The economy may grow again, but it’ll be a long slog before we return to the good old days.

There is, however, a third possibility: a “W-shaped” recession. Granted, it’s rare and frightening, but several well-known economists warn it is very possible. The last time it reared its ugly head was the early 1980s, when the economy dipped into two recessions within the first three years of Ronald Reagan’s first term, and before that, it was the Great Depression, when the initial recovery was brought to a halt by deficit hawks who forced Franklin Roosevelt to raise taxes and balance the budget in 1937.

Investors disagree. All summer, the story has been the stock market rally that looks to be pulling us out of the recession. After a terrifyingly close call from the collapse of Lehman Brothers to the passage of fiscal stimulus, banks have raised capital, Detroit has escaped bankruptcy, and one-by-one economic data seem to be following the stock market’s lead and forming a bottom.

But something is amiss. “We’ve never had six-month period before where we’ve lost two million jobs and the market’s gained 50%,” says Wall Street expert Barry Ritholtz. “That’s simply unprecedented.” Ritholtz thinks the rally will reverse, and if today’s dismal performance is any indication, investors should pay attention.

So who’s right? Let me first say that you should never ever make a financial decision based on my opinions. If financial economics teaches us anything, it’s that the stock market is next-to-impossible to predict, and even if it weren’t, I’m not confident enough in my financial savvy to be responsible for your risk-taking. That said, I’m with Ritholtz on this one, for the following reasons:

1. As indicated above, unemployment will remain high for some time, and with unemployment comes…
2. …foreclosures, which show no sign of slowing down. Government intervention has helped many people, but if we want to make a dent in the larger economy, stronger intervention is required.
3. A whole slew of adjustable-rate mortgages still haven’t reset—which is to say, some homeowners are about to get hit with higher interest rates—so you can expect more defaults.
4. Repeated reports indicate banks still have too many toxic loans on their books. If the Obama administration had taken the advice of many of us and run the worst offenders through FDIC receivership, we wouldn’t have this problem, but alas investors will start to get worried if these reports keep coming.
5. September is historically a bad month for the stock market.
6. Far more insiders—people who know what’s under the hood, so to speak—are selling than buying.
7. The easiest way to measure valuation is the price-to-earning (P/E) ratio. If stocks are selling for a lot more than their companies are earning, beware. The historic P/E average is 15. Right now, it’s 100+! Even if you use the more stable “operating earnings” because you think reported earnings have been depressed too low by the credit crunch, it’s still overvalued at 20+.
8. The output gap—the difference between what we should be producing and what we are actually producing—is still significant. Some economists recommend another fiscal stimulus. I worry about dynamic timing, which is economist-speak for “It took you so long to spend the last stimulus, how do I know this one won’t be delayed until the recession is over?” The last stimulus clearly boosted the economy before most of it was even spent. John Maynard Keynes would call that the result of “animal spirits”: Consumers knew the economy was about to get a jolt, so they started spending again. If the stock market dips or foreclosures increase, however, another immediate stimulus should boost “consumer confidence” like the first one did. If Congress can’t get its act together fast, though, it’ll only add excess inflation after the recession ends.

Economists have two fears: (1) From March till now, we have been in a “bear market rally,” which means the rise in stock prices has been false hope amid a longer decline. (2) The entire economy will turn down again.

The first is a financial concern, the second a broader economic one—though of course the first affects the second. I am not predicting anything, but I am saying that we should be cautious for the 8 reasons above. And I am admonishing the Obama administration and Congress for failing to prevent these fears with mortgage cramdown, a larger stimulus with fewer tax cuts and more spending, and nationalization of certain banks. As James Kwak said earlier today, the fact that the TARP loans are showing profits—which Ritholtz rightly debunked as incomplete analysis—only indicates that the government made a bad bet and got lucky. I hope they (and we) continue to get lucky, but for now I’m with Jim Hamilton: I’ll smile when we’re sure this is all over.

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