Should Bernanke Keep Cutting? Yes

Posted by: Michael Mandel on April 28

We live in a boom and bust world—and it’s not the Fed’s fault. As we wait to see what the Fed does on Wednesday, one thing is clear to me: Bernanke and his crew need to keep cutting rates until the economy and the financial markets stabilize, and not worry about the naysayers.

Since the middle of the 1990s, I’ve followed a very consistent theme in my writings. I’ve argued that we live in a high-volatility, high-growth world. High-risk, high-return: The two things go together.

In the second half of the 1990s, we had the Information Revolution, the Internet, and the tech boom. Then we had the tech bust. All told, the combination of boom and bust moved technology—and the economy—much further and faster than pessimists would have predicted in 1995.

Then in this decade we had the China and India booms, along with the housing boom across much of the world. Followed, of course, by the housing bust—but unless the housing bust leads to a megarecession in the U.S., the combination of boom and bust will have moved the global economy much further and faster than pessimists would have predicted in 2001 or 2002.

These booms and busts are not caused by Fed policy, or indeed central bank actions. Rather, they are the natural working out of increasingly efficient financial markets, combined with the much faster transmission of information and ideas across national borders. And these are good things. Over the past ten years, through boom, and bust, and boom, and bust, global per capita incomes have soared.

The question, then, is what should Fed policy be in the face of a bust? Should it try to smooth out the boom and bust cycle? Or should it allow the real economy to take full advantage of opportunities, and then cushion any crash that comes?

More and more economists are arguing today for the first option. They say that the housing bubble came about, in part, because Greenspan kept rates too low for too long, and that Bernanke shouldn’t repeat the same mistake. And they say that if the Fed cuts rates too much now, it will set the stage for inflation and yet another boom and bust cycle.

But Greenspan believed in the second option, and I’m with him. It is not the Fed’s role to smooth out the boom and bust cycle. The Fed is not omniscient, it does not know what the “right” level for the economy and the markets are. The best that it can do is cushion the damage of the bust, both for businesses and for consumers.

The last 10-15 years have had plenty of minuses. Consumers took on a lot more debt than they should have, perhaps $3 trillion worth. The U.S. lost a lot more manufacturing than it should have. And the Chinese economy is probably shaping up for the mother of all busts after the Olympics.

But none of this can be blamed on the Fed. The central bank needs to take care of its particular responsibilities—taking action to keep the financial system intact. And if that means cutting rates again and again, that’s what it should do.


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Reader Comments

P

April 28, 2008 08:21 PM

In Mandel's fairytale world, a recession is never the Fed's, Wall Street's or the markets' fault. The Fed and Wall Street are always right and the markets are always efficient.

There has never been a rate cut that Wall Street didn't like. Greenspan's decisions led to two bubbles and now Bernanke is bailing out the reckless bankers with taxpayer funds. All this in the name of 'smoothing out the markets'. The free economy should be subject to both booms and busts - thats the definition of real capitalism.

If Mandel has his way, the Fed can keep the financial system intact by subsidizing all bank losses.

Balaji

April 28, 2008 09:08 PM

Mr. Mandel, per capita GDP is just an average. The wages of the average American have fallen in real terms for the last 8 years or so. The boom and bust cycles affect average Americans more than they do the rich, to whom a disproportionate share of the GDP growth has accrued. Therefore it is indeed important to keep booms and busts under reasonable control. I am afraid your lopsided, Milton Friedman-ish free market, cut-throat economics is targeted towards the enrichment of the people who are already flush with money and disregards the fact that it takes 300 million Americans (and not just the top 1% filthy rich) to make the economy work.

Expert Economist

April 28, 2008 09:53 PM

Let me get this straight, its not the role of the Fed to smooth out the boom and bust cycle? Sorry, but that is precisely the role of the Fed. Just completely unintelligent thinking and the type of thinking by so called expert economists that led to the current issues. I guess anybody can call themselves an expert economist these days.

Christopher

April 28, 2008 10:58 PM

The Fed doesn't cause the boom-bust cycles?!?!

What planet is this guy from

richard carter

April 28, 2008 11:01 PM

This wild west mentality the author advocates rewards a small group of people who can manipulate the system at the eventual cost of the rest of us. Rules and regulations can to a degree level and protect the playing field. It is not a have or have not situation. Moderate changes usually means people have an opportunity to think and better direct change.

Linda Ogren

April 28, 2008 11:36 PM

So, then, you are a macro-economist. For the individual, though, timing is everything. Your comments suggest that not putting all one's eggs in one basket remains good advice -- be it career or investment or business or national policy. Excuse me while I focus on trying to catch the next wave.

David B

April 29, 2008 12:26 AM

The argument is that the economy runs on cycles that are not caused by the Fed. Why, then, should the Fed do anything to cushion the bottom of the cycle? It seems like a contradiction to ask the Fed to avoid trying to prevent problems but to require them to fix problems once they've hit. And, if the boom bust cycle is an efficient way of taking advantage of opportunities, why shouldn't we be just as skeptical of the Fed cushioning the bottom as of it cutting off the top.

That's why Volker is twice the man Bernanke will ever be.

Disgruntled

April 29, 2008 01:16 AM

Yes, keep cutting. Let’s cut the rate so low that ordinary people must actually pay the banks to house their money. Better yet, let's create incentives to these ordinary people to buy nothing but stocks, and then create a few more Bear Stearns deals. Reminds me of the old tax adage, you collect zero taxes at tax rates of 0% and 100%.

Ajay

April 29, 2008 01:24 AM

Nonsense. Most of the money in the booms were wasted on stupid dot.coms and wasteful McMansions. For every pessimist that you can produce from the 90s, I can produce 10 that said we'd be MUCH further along. While I agree with you that the Fed should butt out, booms and busts are clearly not the product of efficient markets, though I will agree that they may be a natural process akin to predator-prey cycles in nature. Efficient markets would reward successful investors like a Buffet or seed investors, rather than continuing to throw money down pits like Yahoo or venture capital funds. While I agree that we should let markets alone to proceed with their Darwinian process of winnowing the wheat from the chaff, there's obviously a lot of chaff in current markets.

I appreciate your sentiment that the Fed should be ignored, I would rather just abolish the institution altogether. Just as Buffet's supercat insurance takes care of insurance markets, other market institutions will always be there to maintain stability.

Dominic

April 29, 2008 01:50 AM

Michael you said:

"These booms and busts are not caused by Fed policy, or indeed central bank actions. Rather, they are the natural working out of increasingly efficient financial markets"

The statement above contain a clear contradiction.....

DDV

April 29, 2008 02:08 AM

Stocks are rising (despite many experts claiming this to be the worst recession since the great depression) because the US Fed has made it known they will support the market at all cost even though the result is severe inflation and the creation of the next bubble. So psychologically, market participants are not afraid because they have an insurance coverage in the form of the irresponsible & reckless US FED.

DDV

April 29, 2008 02:09 AM

Major Economic Scenarios

A. Pro Economic Expansionist Governments

In this day and age Governments and politicians seek only to ensure economic expansion (note: In the Clinton Years inflation data was actually manipulated to reflect lower inflation) indifferent to everything else especially Inflation & Speculation.

In some cases Governments actually unbalance the playing field by estalishing Sovereign Funds to enhance their profits and thus competing with the private sector in pushing asset prices and subsequently inflation higher.

B. Flaws of Globalization

Obsessed with growth, Governments expand free trade and encourage globalisation thus opening their countries to greater economic imbalances especially when there are sudden movements in the flow of "hot money" (ie. classic example in the 1997 Asian financial crisis). Just imagine if some countries did not protect their farmers, what would have happened in this current "food inflation crisis"? Free trade have effectively placed some economies at the mercy of others! Thus, has National Security been compromised?

C. Hyperinflation

The factors above have now pushed the world into a hyperinflationary period. The US Fed has EVEN reduced interest rates in the face of severe inflation giving birth and stoking the next bubble. See how twisted Government policies are nowadays! Luckily, we still have a responsible Euro Central Bank.

D. Increasingly Polluted World

Governments in search for economic growth have effectively forgotten the environment.

Andrey

April 29, 2008 04:12 AM

Sorry to read this at the pages of BW. The boom and bust are largely hand-made, and guess who is to blame. To struggle with the consequences of one's own consciously made mistakes is a child's business. Market corrects itself and Fed's influence has hardly ever made the financial system working in a more sound way in the long run. It is not the free market that gives birth to boom and bust, because

[In the US] capitalism should not be condemned, since we haven't had capitalism. A system of capitalism presumes sound money, not fiat money manipulated by a central bank. Capitalism cherishes voluntary contracts and interest rates that are determined by savings, not credit creation by a central bank. It's not capitalism when the system is plagued with incomprehensible rules regarding mergers, acquisitions, and stock sales, along with wage controls, price controls, protectionism, corporate subsidies, international management of trade, complex and punishing corporate taxes, privileged government contracts to the military-industrial complex, and a foreign policy controlled by corporate interests and overseas investments. Add to this centralized federal mismanagement of farming, education, medicine, insurance, banking and welfare. This is not capitalism! --Ron Paul

Alan

April 29, 2008 04:21 AM

The question is not whether to adjust the rate anymore but rather who will be the beneficiary of the outcome. Lower rate will benefit the stock investor (no doubt) more or to the subprime house owners who are already scalping the bottom due to high petrol and food prices. The owners probably already stop paying the mortages and divert all their incomes to fill their stomachs. Does it still matter to them what is the rate will be tomorrow or next year?

Sean

April 29, 2008 05:32 AM

The author seems almost "embedded" within the Wall Street firms that stand to benefit from this sort of spin.

If we live in a boom/bust "dynamic" capitalist economy, how does the author feel about using taxpayer money to bail out Bear Sterns? How about the plan Bank of America lobbyists have been shopping any Congressman who will listen (the "plan" is for the Congress to create a government fund that will buy up about $750 billion in bad mortgages that apparently the "free" market doesn't want).

The problem isn't that the Fed will "punish" financial firms and banks by not cutting rates, it's that it has made outsized promises privatizing profit and socializing risk/losses. The problem with Greenspan's Fed and now even worse with Bernanke is that the excess is encouraged because the Fed is there to back your losses.

It's not just about rates, it's about backing losses with taxpayer money. It's also about pandering to banks to let them make outsized profits that the media reports as "repairing their balance sheets." The way that repair works is like this: the Fed slashes rates that banks pay to borrow money and then banks turn around and increase the rates they charge their customers on mortgages, credit cards, car loans, etc. This "spread" is their profit. In times of insolvency, the Fed likes to make that spread fairly wide.

Have your credit card rates, car loan rates, or mortgage rates dropped since mid 2007 when the Fed started it's massive rate cutting campaign that cut the cost of borrowing almost in half in less than a year?

The immorality of the Fed holding rates low is that what it does essentially is gives freshly printed money (credit) to banks that devalues all of the money already in circulation. Tell people who don't like $4 gas and $5 for a dozen eggs that inflation is manageable right now. It is not.

The Fed can't inflate the money supply to try to hold up stock and home prices without the price of just about everything rising. Unfortunately, for 90% of Americans, that is a very bad thing because it renders their salaries insufficient for necessity. Inflating the money supply is like giving Americans a stealthy pay cut that they don't quite understand. It is immoral.

If this is a free market economy, then how about letting the investment houses and trading firms find their own bank or investor to borrow from. And if they can't find one, then I guess they need to declare bankruptcy. If my business was facing bankruptcy, I'm fairly sure the Fed wouldn't loan me a lot of money and ridiculously low interest rates.

The 12 month trailing CPI was over 4.3% (and US CPI is such a misleading number with hedonics, substitution and other mechanisms better suited to measuring subsistence living rather than inflation). With CPI at 4.3% and the overnight rate at 2.25%, I'd say that the Fed is fairly well encouraging banks and investment houses to borrow money.

A long time ago one of the saving graces of a recession was price deflation. This allowed households to better afford necessities using savings during rough times. But today, it's all inflation. During periods of growth there's inflation and during recessions and depressions there is inflation. This deeply harms 80% to 90% of Americans and we should not tolerate it any more.

TY

April 29, 2008 11:03 AM

Maybe Americans feel the fed existent is redundant. but funny and sad is to say the world and even the top economists from other developed nations listen to them. Everyone gov wants to control the economy , it not possible for the Fed to be dissolve. At least the Fed is transparent about their decisions, I cant say that for many nations who are poorer and facing a inflation crisis.

pepx

April 29, 2008 12:40 PM

Actually the FED have been on boom and burst since the greenspan years. the previous shocks were oil shocks in the 70's and the 80's, yet the economic fundamentals weren't as unbalanced as they are now.
the recent slowdown is mostly result of the bad management in the interest rates set in early 2000's, when the "mild" recession wasn't enough to clean the bad balance sheets, and the bad investments made during the tech boom, a real recession was stopped by all means, unfortunatly the extremely low rate set in those times, helped to fuel the housing boom.
in a reflection we should consider how real was the past expansion (considering the real output created and the new job generation, productivity, etc, all discounting the construction activity from the record and related sectors).
also the past recession could hardly be called "boom" considering a slightly above 3% growth from 2003-2007, when in the 90's the economy managed sustained periods of 4% growth, rising wages and lower inflation, proving that productivity growth was also lagging, yet no one worried much about that either, whatever unfortunatly US is paying for the easy credit of the FED in 2001-2003 and is about to do the same again, lets wait for greater consecuences.

Mattyo

April 29, 2008 01:25 PM

"But none of this can be blamed on the Fed. The central bank needs to take care of its particular responsibilities—taking action to keep the financial system intact. And if that means cutting rates again and again, that’s what it should do."

The Fed has two basic responsibilities. First, to promote stable prices and second, to foster economic growth. The former has been thrown out the window under this Chairman to support the latter.

I am definitely not going to say that the Fed is in the wrong here - Bernanke was responding in order to keep this card castle standing; however, there has to be some lower bound here, and it can't be 0% discount.

I think the real problem here is the cause of the turmoil - bad business decisions. When your firm has made calls that have lead the nation into macroeconomic turmoil you really need to reconsider how you are doing business.

I understand and am a fan of risk, reward, and returns but honestly - how did we get here?

Mike Reardon

April 29, 2008 01:36 PM

I think we will creating a by-functional market response, we do live in a boom/bust "dynamic" capitalist economy and the Fed will stoke like a furnace any next business bubble. I would say we still have corporate consolidation as a generator of income to investors and as a drawing card for large foreign investment. And then we also get the second response that will come from Congress and the next President, and that will regulate the issues inside housing and consumer debt. We get built in deficit finance from government supporting the lower consumer banks and the "dynamic" investment banks gain profits from larger deals consolidating the markets and returning profits to investor. Its is not necessary to gain exponential expansion from these responses, all we really need is a stable flat balance that can work out the past imbalances. The world outside still has an expansion were we can gain return on past investments. The Bank of Japan supported ten year of sub-par growth so as to give space for a stable domestic market.

Karl

April 29, 2008 05:45 PM

Could any of these have anything to do with all of the problems we're now realizing; FRAUD, GREED, CORRUPTION, MANIPULATION, & the PURSUIT TO FINANCIALLY INJURE the INNOCENT??? When will America ever wake-up???????????

TriNguyen

April 29, 2008 06:11 PM

I totally agree with Michael Mandel "We live in a boom and bust world" and the business cycle has become harder to predict. Politicians and FED Bernanke have very little controls over the economic cycle. The inflation caused by everincreasing oil price and food price is a result of higher demands from developing Nations mainly China and India. There are more and more people in developing world moving to middle class and they spend more on gasoline and foods. Therefore, I think the current economic situations reflect the nature of SUPPLY-DEMAND curve.

Viking

April 29, 2008 10:59 PM

Is this the same Mr.Mandel who wrote recently about the 3 trillion debt piled up by the american consumers in the last decade?Is he employed by Business Week to play devils advocate,because he cannot be serious about this article,at the same time he worries about what the 3 trillion debt will do to our economy in the next several years.Clearly there is a connection between the extreme low interest rates put in place by the Fed after the dotcom bust and the extreme debt taken on by the consumers.At some point we will have to pay the piper and we used to accept that recessions were part of the business cycle and the associated pain.Now everyone in Washington including the Fed wants to avoid recession by printing money like mad and giving tax rebates with money we do not have.This is stoking inflation,so we pay in another way,who are we kidding?Let us bring Paul Volcker back to the Fed and restore some sanity!!!

stock_champ

April 29, 2008 11:39 PM

Access to cheap money will always create a bubble somewhere. The question is where is the next bubble and when is it going to burst?
http://www.themarketnewsletter.com

Bruce

April 30, 2008 11:08 AM

Sorry, but I disagree with the main idea of your article...I would not classify myself as a pessimist, but a realist...I think I look at the reality of investing, and our Fed has certainly made that interesting..."may we live in interesting times".....curse or blessing.

Mike Mandel

April 30, 2008 12:28 PM

Viking wrote:

"Clearly there is a connection between the extreme low interest rates put in place by the Fed after the dotcom bust and the extreme debt taken on by the consumers"

To some degree, though the low long-term rates had a bigger impact. But given that banks and other lenders are tightening terms, we are getting a tightening of credit even with the lower rates.

Viking

April 30, 2008 01:47 PM

Yes,Mike i agree that long term rates had a bigger impact,fueled by a large pool af savings in the developing world,made available to the american consumers.This was the reason for the inverted yield curve that we had for a long time,as the Fed started raising rates and the famous "conondrum" remark by Alan Greenspan.However the Fed should have been much more agressive in raising rates as it should have been clear to them that they kept the rate too low for too long,as a way to pop the housing bubble,before it got out of hand.If the Fed simply follows the market expectations why do we need the Fed?Just let the market set the rates including the short end of the curve!!!

SamCVG

May 1, 2008 02:18 AM

I have noticed a disturbing trend of late, even in pages such as these: anger.
And there is, too, a paucity of metaphors or mathematics inherent in the arguments.
It should be noted, from the beginning, that the concept of economic efficiency is amoral; it has long been justified by various arguments, from JS Mill to Rand. But the the goal in economics is simple: more.
To a certain extent economics, in its essence, is as horrific as evolution: more and an endless variety.
Given this foundational idea, what can the fed do?

Keith G

May 1, 2008 01:46 PM

I've got to agree with the idea that despite this painful bust of the housing bubble the overall process from start-to-finish will see an overall increase in home-ownership than if the bubble-bust cycle did not happen. It will be an interesting analysis to perform once this all shakes out (2Q2009?).

I'm not sure how much is the Fed's doing. Because, as we are more-and-more tied to global capital markets (and as others become bigger and bigger players) the Fed's impact and influence should become less.

MIke Mandel

May 1, 2008 04:57 PM

Keith G writes:
"as we are more-and-more tied to global capital markets (and as others become bigger and bigger players) the Fed's impact and influence should become less."

Keith,

Good point! That's the idea I've been trying to inch up on. We give the Fed far too much credit and blame, especially given the growing importance of the global economhy

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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