Monday, September 18, 2006

I'm Back

I'm back to writing for this blog, after a hiatus of a few months. In the future I will try to concentrate on analyzing current political and economic events, but I may write a few essays as I have done in the past on various theoretical subjects.

The Federal Reserve meets on Wednesday (2 days from now.) Many analysts are predicting the Fed to keep the interest rate at 5.25%, but I think that would be a grave mistake, and an indicator of the Fed's willingness to allow excess liquidity to flow not into customary inflation, but into asset markets, such as the housing market. A huge housing market bubble has resulted, and has fueled American consumer spending. As America's economy is reliant on heavy consumer spending, a burst in the housing market bubble, which would greatly reduce the purchasing power of American households, would be disastrous.

Yet this type of bubble is exactly what the Federal Reserve (and China) continues to finance. In 2003 the Fed slashed interest rates to as low as 1% out of a fear for deflation. Why? The Fed obviously still has bitter memories of the Great Depression, in which deflation resulted in a vicious cycle of economic stagnation. But the economic situation of the 1930s is not at all similar with the economic situation of today. A comparable time period would be the 19th century, when the industrial revolution greatly increased production and thus lowered prices, resulting in deflation. Today, new industry and technology do not have as much to do with the global economic boost as does a new phenomenom: gobalization. During the industrial revolution, deflation was accompanied by great economic growth, so the fear of inflation that the Fed exhibits today is entirely unfounded.

So how has globalization contributed to lowered inflation? Emerging economies, most notably China, are able to produce goods at much lower prices than developed economies such as the United States. Thus, an influx of cheaply priced goods into the US results in lower prices across the board, holding down inflation despite economic growth and lax monetary policy.

So if monetary policy is lax, meaning there is a large amount of money in the economy, and prices are down, where does the money go? Into various asset-markets, most notably the housing market. The Federal Reserve should have encouraged deflation, and kept interest rates high, thus preventing the housing market bubble. Is it too late to fix the problem? I think a backlash of some kind from the bubble is inevitable, but the Federal Reserve must take note of the severity of the situation. Inflation has slowed in recent weeks, due to lower oil prices and a slowing of the housing market, and the Federal Reserve should attempt to continue that trend by raising interest rates at its meeting on Wednesday. This would allow the housing market to become progressively depressed rather than building up the bubble, only to have it burst instantaneously, throwing millions of Americans into economic disarray.

Some pessimism: “This soft-landing scenario is a fantasy,” says Ed Leamer, director of the UCLA Anderson Forecast."

And some more from the same economist: “Anything housing-related is going to feel like a recession, almost like a depression.”

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