The Federal Reserve surprised the markets last week when it announced it was going to continue its easy money programs instead of starting to taper off a little. In response, stock market indices hit new records.
It seems that most economists and other experts think that what the Fed is doing is fine. They support the Fed’s policy of near-zero percent short-term interest rates and the bond-buying program ($85 million a month) that is designed to push down long-term rates. The idea behind these policies is at least twofold. One is to encourage businesses to expand and grow by making it cheaper to borrow. The other is to encourage (force-?) investors to move out of bonds and into other investments to get a better return on their money. This will increase stock prices, which will make investors feel richer. When people feel richer, they spend more, which will cause the economy to grow and create more jobs.*
According to standard economic theory, and the models the policy makers are using, these policies should be continued, as long as inflation stays low, until the economy gets to a level of steady growth. Also, the models give the experts the confidence that, when it is time to cut back, they can do it successfully, without slowing down growth or spooking investors. I wonder.
If the Fed had known in 2008 what would happen when Lehman Brothers went bankrupt, they would have done something differently then. But the fact is that the Fed, et al, didn’t realize what was going to happen when Lehman went under because they were in a situation they had never been in before. And that’s where we are today, too.
I worry that the Fed’s models are missing, or at least are not including, the human element. People aren’t always rational. While I think it is appropriate to use standard theory to determine policies, you also have to factor in the fact that weird things happen. You need some extra cushion. You need a safety margin in case things go off the rails in ways you didn’t expect. This is especially true in situations like we are in today. We have never been here before, so our confidence in our models and theory ought to be a little less.
When I saw the markets shoot up after the Fed’s announcement, the market’s reaction made me think of a drug addict. As long as they can get their fix (in this case, easy money), everything is fine. What worries me is what’s going to happen when the Fed finally cuts off the easy money (and it is going to happen some day).
I recently saw a movie, “Christiane F.,” about the teenage drug and prostitution culture in West Berlin in the late 1970s. The scenes of Christiane and her boyfriend going through withdrawal were very scary.
I worry about the same thing happening to the economy when quantitative easing and super-low interest rates end. As I said above, we are in a situation we have never really been in before. We know what the models say, but the models didn’t get it right in 2008 because the situation was new and the models didn’t include it. Also, the models can’t account for panic – because you can’t know what panic is going to do or when it’s going to happen.
Unwinding the Fed’s easy money policies isn’t going to be easy. The experts might think their theories and models tell them how to do it, but it is unrealistic to expect models to tell us what is going to happen in situations we have never been in before. The likelihood of things going like the models predict is slim. And when they don’t, it’s going to be scary. But we have to do it.
Let me, therefore, suggest three things with respect to the “Great Unwinding”: First, set clear rules – and follow them. The Fed, et al, shouldn’t start changing what it is doing just because things don’t go exactly like it expected. A firm commitment to follow clear rules is the best way to avoid the uncertainty and confusion that breeds panic. There are going to be enough problems without adding uncertainty to the list.
Second, we need an extra margin of safety. Things aren’t going to go according to the plan – they almost never do. Building in a bigger than normal safety cushion will limit the risks and fears when things don’t go exactly as planned.
My third point is tied in with the first. Don’t try to micromanage the unwinding. As long as it is headed in the right general direction, that’s good enough. With clear enough rules, and a big enough safety margin, there should be no need to micromanage. But don’t do it in any case. It just adds uncertainty and the possibility for confusion, and those are the things with the greatest chance to make matters worse.
Kicking the easy money habit isn’t going to be easy. It’s going to be painful, and we are going to
wish we did not have to do it. But it’s
only going to get harder the longer we wait.
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* Talk about “trickle-down economics”.
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