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Can the Fed Manage the Economy?

I have been a big fan of Ben Bernanke, who along with Hank Paulson jumped into the fray to rescue the economy from it’s meltdown last fall. I think it is great that he is a student of the Great Depression and is using his knowledge to try to avoid another one. Things seem to be looking up, but there seems to be some question about whether the green shoots that are springing up will be viable.

In a way, however, despite the fact that Bernanke has done things the Fed has never done before, what he is doing now is the easy part. In general, people are not going to complain too much when you are handing out free money. There will be complaints from the people who are not getting it, which we are seeing now, but it’s not like sucking money out and making life harder for people, not just making some people comparatively poorer by handing out money to others. Although their Wall Street neighbors are rich and getting government handouts, regular people are better off than they would be if the Fed had done nothing. It’s just that maybe they get to keep most of their jobs, while Wall Street not only gets to keep its jobs, it gets huge bonuses to boot.

Although this course of action seems correct, you have to wonder why the solution to the current meltdown is the same medicine that caused the meltdown — low interest rates, more consumer spending, freely available mortgages, etc. Doesn’t this encourage the same bad risk borrowers to borrow more? They say that refinancing is way up because mortgage rates are at their lowest rates ever. Are these just people turning their homes into ATM machines who missed the last go-round? Instead of more profligate spending, don’t we want to encourage more responsible conduct? Ridiculously low interest rates do not do so. People are saving more, but if the interest paid on their savings is virtually nothing, that’s not encouraging them to save. If people genuinely expected deflation, that would encourage them to save, because even zero interest is valuable if each dollar buys more at a later date. Yet, the Fed has said it doesn’t want deflation either.

The future is more of a problem. If the Fed doesn’t turn off the money spigot at the right time, perhaps at exactly the right time (which is hard to determine in real time), then inflation may take off. When it turns off the money spigot, people will experience real financial pain, not just envy. The one person who’s done this is Paul Volker. Under him a 14% mortgage was a good interest rate. Will Bernanke be willing to do this? How much political pressure will he come under not to do it? Will he know when to do it?

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