Saturday, January 26, 2008
Edouard Manet, Olympia (1865)
I'm watching John Edwards on C-Span from a rally earlier today in South Carolina. Someone asked him about the economy, and now he's all talking about the need to stimulate the economy, how we should've stimulated the economy before, etc. Everyone's talking about this now: everyone wants to freaking stimulate the economy. Is the economy frigid? When do we get to consumate with the economy?
Cutting interest rates, as the Fed did in their emergency action earlier this week, could work, but as most of you know, there are a number of dangers in this approach. First, lowering the interest rate often increases the possibility of inflation, but that seems unlikely, since consumer spending seems to be decreasing as a result of the housing crisis (and the psychological impact of the crisis). Inflation could result (and appears to be developing) due to higher oil costs (which spreads higher costs across the economy) and the lower dollar, which makes imports more expensive. (It's interesting to consider just why inflation may be a bad thing. Too often, we just assume inflation is bad. Many economists agree that a little inflation is actually a good thing. It's just when it gets a bit out of hand that things go all pear-shaped.)
Second, pushing the interest rate down in an effort to ease the credit crunch may be useful as a short term balm (i.e., to stanch the bleeding in the global capital markets for a week or two) but the Fed's determination to keep pushing the economy along and avoid deflation by keeping interest rates at historic lows for the past half-decade or so was a prime factor in creating the very housing bubble that's now popping. That is to say, the Fed may well be prolonging or briefly postponing the misery, a misery which may in fact be necessary as a corrective.
Third, this may well be self-defeating. Lowering interest reduces the attractiveness of U.S. investments such as bonds. With less investment coming in from abroad, we face the specter of crowding out, as there is a growing demand by debtors (the U.S. government being chief among these) to fill this void -- again driving up interest rates.
This is making my head spin. I'll write more later.