Ev Ehrlich's Everyday Economics

The Year of Cheap Money

First, the Winter Olympics.  I have the highest regard for the inherent athleticism of, for example, an ice dancer or mogul skier.  But you know what the Winter Olympics needs?  Ice boxing.  Think about it – 19 year old George Foreman, fresh out of the Job Corps, pounding Russian favorite Ionas Chepulis in 1968 – on skates.  No, you can’t fight on skates, that’s ridiculous…ever been to a hockey game?

And, again, I’m talking about people who put their life on their line for an athletic competition, I know, but I feel like I’m watching the Jackass Olympics.  When is Johnny Knoxville going to run one of these skeleton sleds down the chute?    Cut to the ice boxing, please.  Or…ice kick boxing!       Nick Ehrlich would go for that.

OK, maybe I better move on to the economy, even if the videos aren't as exciting.

Last Thursday, the Federal Reserve’s Open Market committee – the group that sets monetary policy and that you think of as “The Fed” – announced that it would begin to consider how and when to raise interest rates, and as a demonstration of what’s to come, they raised the “discount rate” from 0.50 to 0.75 percent.   The discount rate is the interest rate the Fed charges banks when they borrow from it.  If your credit card was the Fed and you were a bank, the “discount rate” would be around 18 percent; if a mob loan shark was the Fed and you were a desperate borrower, the “discount rate” would be a bunch of points a week and a broken long bone if you were late. 

The point of this announcement is this – the Year of Cheap Money will soon be over.  Oh, interest rates are going to stay reasonably low for some while, but the arrow is now up.

A couple points at the outset.  First, this wasn’t all that surprising, although it was probably a little sooner than many people expected.  Second, it was the right thing to do.  Third, the announcement wasn’t as interesting as the next few moves that follow it will be.

Regarding the first point, Chairman Bernanke said a few weeks ago that interest rates would remain “extraordinarily low” for a long time.  Now he announces that the direction for rates is up.  But the two aren’t inconsistent; whether the rate is 0.50 or 0.75 percent, there’s plenty of room to raise it before we would regard interest rates as anything other than forgiving.  The most interesting part of the timing is that the announcement was made between the Fed’s regularly scheduled meetings to decide such things.  It’s a good way to make sure you get everybody’s attention.

Bernanke’s announcement makes clear that the Fed is focused on the important difference between creating credit conditions that support a growing economy and job creation, on the one hand, and conditions that allow banks to make more money to restore their capital, on the other.  Up to now, the latter has been an important part of the mix – with so many banks having taken a bath on the collapsing value of their mortgage-related and other loans, a major objective of monetary policy has been to help these banks get on their feet.  The Year of Cheap Money has let them earn very big profits and helped to restore their capital – capital being the money under the floorboards that ultimately secures their business.  After all, banks can borrow from the Fed at less than a percentage point and then buy the safest government bonds for about 3 percent.  Like it or not, subsidizing these guys has been a conscious objective of policy.  And that policy has worked, and worked well. 

So it’s time to move on.  The Fed is signaling that it’s going to shift, slowly, steadily, and as circumstances warrant, towards a more neutral policy, which probably means a federal funds rate of 2.5 percent or so by the end of 2011, a gain of a little more than two percentage points.  By saying that, I’m really saying that I stand by my view that the economy is going to rebound more energetically than we think right now and that employment gains will be surprisingly strong, soon.  If it does grow the way I think it will, you won’t mind the rate increases.  And if there are any signs of the economy going back into the tank, all this talk about gradually raising rates is going to be put to the side.  But there won’t be, and it won’t be, or so I’m betting.

There are critics on both sides of this policy, and to me, the very symmetry of their criticism is good evidence that they’re both wrong. Some claim that the Fed is already too late – that all this easy credit and cheap money mean that we’re going to have a round of rising if not severe inflation.  I don’t get this at all, for reasons that probably deserve more space than I’ll give them here.  But to imagine that with one out of every ten American job seekers out of work, millions more waiting to go look for a job when it won’t be a waste of their time, and tens if not hundreds of millions of people in the world economy producing goods and services we can buy here at home, believing the idea that “inflation happens when too much money chases too few goods” in almost a compulsion rather than a framework for understanding the economy.

The other critical perspective is that raising rates and ending the overt subsidization of bank profits is going to lead to bank failures and throw us back into the soup.  I don’t disagree that making it a little harder for banks to borrow on the cheap down the road will lead some smaller, regional ones to be pressed, and some flattened.  But life is unfair.  I’m not opposed to some banks failing – I’m opposed to all of them failing at once.  Now that we have some devils walking around, they can go back to taking the hindmost.

But all of the back and forth about the end of The Year of Cheap Money has this context – why has (and still does) the Fed lend to banks at these miniscule rates to help restore their profitability while there are tens of millions of Americans that are still suffering in large part because of these same banks’ behavior?  I was having dinner with a friend the other night – a guy who had a pretty successful career and has some fairly conservative instincts -- but he suddenly told me that, as moral proposition, the difference borders on corrupt.  Why must we tolerate it?

Because your rear end is spot-welded to those banks, at least for now.  Losing the auto industry, for example, would be a severe disability for the economy.  But people learn to accommodate and rise above disabilities.  A collapsing financial system is like an acute cardiac crisis – you don’t survive it.  Had the banking system collapsed – as it was on the verge of doing – there would be no lending for payrolls or materials, no financing for investments, no nothing.  There are probably free market devotees who argue that some new lenders would emerge and that the major institutions that dominate our economy would soon not be missed if they were allowed to fail.  That looks good in chalk on a board, but to imagine that the economy could make a transition to a new set of institutions, or the wholesale reorganization of the wreckage of the old ones, without a profound dislocation is laissez-faire pie-in-the-sky.

And that takes us back to financial regulation and the role of markets.  Markets are very good at balancing competing views – bulls and bears, buyers and sellers, optimists and pessimists, eat-no-fat and eat-no-lean.  But when everyone stampedes in the same direction, or has the same problem, markets don’t work as well.  Sure, some contrarians make money – I proudly tell you that I bought Citigroup at a dollar a year ago, my theory being that if Citigroup wasn’t worth more than a dollar a share, I’d be burning money for heat in a cave somewhere pretty soon, so I might as well buy the stock – turn a low BTU dollar bill into a high BTU share of stock.  But the success of contrarians isn’t proof that markets alone can get the economy to grow and sustain our standard of living when it hits the fan.

Which goes back to seizing the moment and passing financial regulation that assumes that crises are going to happen as opposed to being shocked – Shocked! – when they do.  And if that means passing the Volcker Rule (a good idea, as I’ve said), or putting limits on their size relative to the economy, or even enacting the much-disliked (by economists) “Tobin Tax” – a miniscule charge on all financial transactions that would fund, in part, a pot of money that could be used to shut down broken banks and keep the economy going while they rot and vultures pick their flesh – then let’s go.  I trust the market at Sears, I trust the market when I hire people or am hired, but I don’t trust the market to prevent the kinds of disasters we’ve just seen. 

That’s not a call for any and all approaches to regulation, just a statement that it’s time to get real about what type of regulation we need.  Because if the alternative is to have The Year of Cheap Money so that men in suits in tall buildings can borrow cheap and lend dear, then we can’t do much worse.