Thursday 20 September 2007

Pic of the day: So, like, the property market totally collapsed, you know? So shouldn't we, like, panic or something?
(Fictional picture, I'm happy to say. From the computer game City of Heroes.)

Fed rate cut

Usually I agree with The Economist magazine. After all, it is well researched and largely impartial, at least to things outside the United Kingdom, where it is based. Probably there too, but its coverage there is too detailed and intricate for me to have an opinion on.

Occasionally, however, I disagree with them. My disagreement probably has very little effect on the world, since I am just some guy. This may be just as well, since I am also sometimes wrong. Most notably, I claimed that the slump in 2001 would become a long, slow recession. As we know, I was disastrously wrong. Thanks to reckless (or perhaps ruthless) overspending by the government and populace alike, America continued to party for borrowed money. True, wages stagnated and production faltered, but the frenzied buying of the same houses for ever more money made the statistics show that the country was growing briskly, and people acted accordingly. I've learned from this that the market is NOT rational. Economic models are much like the cookbook for physics students: "Assume a spherical chicken of uniform density…"

The Americans, I'm afraid, have learned a very different lesson: "There are no more recessions. If things look down, the government and the Fed will save us." And what bothers me is that the Fed is obliging. True, the contraction in the credit market was pretty dramatic, and the quake in the subprime lending market has paralyzed the construction industry. But the stock market is still doing well. In fact, it rose to a foaming frenzy on the news of the interest rate cut.

Dear central banks, you don't counter a monetary contraction by cutting interest rates. You counter it by pumping liquidity into the market in the form of temporary credit. Cutting the basic interest rates should be reserved for when there is a risk of deflation. Falling house prices is not deflation if rising house prices were not inflation. (This can certainly be debated, but the fact is that the Fed did not worry overmuch over the rapidly rising house prices until at the very end.) Conversely, you counter the threat of inflation by raising interest rates.

Let us take a look at the US economy and try to decide whether it is headed for deflation or inflation. Deflation, for the non-economist that may have joined us, is a state of falling prices and falling wages. It is a very serious condition, because people just skulk around without buying anything more than the daily bread. After all, it will be cheaper next week, next month and next year. Borrowing money is a no-no, because you will have less money to pay it back with. It is also hard to solve, because you cannot set interest rates lower than zero, which they ought to be for fairness.

Inflation is the more familiar scenario where prices rise so fast, you don't know exactly how much things cost even though you used to know. It becomes hard to compare prices. It becomes hard to save money, since it is worth less and less. Interest rates need to be correspondingly high. You have to constantly negotiate your salary to not fall behind, and it is hard to guess how much is right. People hurry to use their money while it is worth something, and bad choices are made.

Now, which one looks like America? I think we can say that if we don't count the house prices, most things are getting more expensive. Well, there are always electronics, but then again there have always been electronics for as long as we can remember. But with gas prices remaining high, food prices exploding, and import prices slated to go through the roof… I think there is no reason to expect deflation anytime soon.

This may not be obvious to the American reader, but the rest of the world has noticed that the dollar is sliding really fast now. For instance, to me as a Norwegian the dollar is now 10% cheaper than earlier this year. That's nice for Americans wanting to export, but it also means that all their imports will be correspondingly more expensive. This includes many raw materials for products made in America. And given the massive US debt, there is little hope that the dollar will strengthen again in the foreseeable future. Quite the contrary: If the US$ loses its status as the World Currency, it could fall far and fast. Even if not, it is bound to slide as long as it remains official US policy to tax little and spend much. And so the prices will continue to rise.

Also notice that so far, China has held inflation at bay by selling extremely inexpensive goods, and have pegged their currency against the dollar so that this effect continues no matter how much America debases its coin. But ironically, many US politicians are clamoring for China to unpeg its currency. The Democrats are especially vocal in this, and now have control of Congress and Senate both. If they succeed, the price of many everyday goods will rapidly rise. (Of course, this is what the protectionists wanted, because this means American companies can sell their competing goods, which they could never manufacture for any less than expensive. In this strange logic, expensive goods is a good thing... just not for the people who have to buy them. You may correctly have guessed that I disagree with the protectionists. If the Chinese want to give gifts to the Americans, why not let them?)

I am not sure whether Ben Bernanke just want to be nice and save America from recession, or whether he makes the logical fallacy that "rising house prices is not inflation, falling house prices is deflation". A homeowner surrounded by homeowners is very likely to get used to seeing higher house prices as a good thing. And by allowing inflation to rise all across the economy, the rising tide will also cushion the fall of the house prices. True, their real value will continue to slide since all other things become comparatively more expensive, but the nominal fall will be less. And this would be enough to console ordinary people. A professional economist should be immune to this lure, but I have to wonder. Ben Bernanke is weathering his first crisis as leader of the Fed. Does he have what it takes? The world is watching. Well, the economists of the world are. But the outcome will affect the whole world.