Between a Rock and a Hard Place, But It Didn’t Have to Be This Way

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.

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