First, an apology: I’m not very good at this whole blogging thing. I’m the kind of writer who likes to go into a cocoon for several days and reappear with a finished work. I get absorbed in my work, and it’s hard to force myself to post something everyday. Some writers find it easier to pour out their thoughts in-the-moment and collect it all into a coherent work later. So I’m back, but no promises about how long it’ll last.
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.
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.