April 20, 2004

Fragment of an Unfinished Ms.

Part II of an unfinished paper, "After the Bubble." The paper currently lacks Parts I, III, IV, V, and VI. I am supposed to talk about this paper (thank God, internally only) on April 29, 2004.

Inspiration had better strike soon, that's all I'm sayin'.


II. Aggressively Expansionary Monetary Policy and Macroeconomic Vulnerabilities

Let us begin with a passage from Mussa (2004), "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" (Washington: Institute for International Economics: April 1), in which Michael Mussa writes about global financial imbalances:

Michael Mussa: ... Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada.... The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.

On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing.

A further concern related to the general monetary policy imbalance in the industrial countries is its effect on emerging market economies. Interest rate spreads for emerging market borrowers have contracted substantially and flows of new credit have increased. The boom in emerging market credit has not yet reached the frenzy of the first half of 1997, but it is headed in that direction. Another major series of emerging market financial crises (such as 1997-99) does not seem likely in the near term in view of the very low level of industrial country interest rates and the favorable global economic environment for emerging market countries. By 2005 or 2006, however, either upward movements in industrial country interest rates or deterioration of market perceptions of the economic and financial stability of some emerging market countries could trigger another round of crises.

Mussa is warning that the high asset prices produced by very low interest rates pose dangers that may turn out to be substantial. One way to read Mussa's warning is as a polite--a very polite--criticism of Alan Greenspan's self-praise of his own low interest-rate policy contained in Greenspan (2004), "Risk and Uncertainty in Monetary Policy" (Washington: Federal Reserve Board: January 3):

Alan Greenspan: Perhaps the greatest irony of the past decade is that... success against inflation... contributed to the stock price bubble .... Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve. It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization--the very outcomes we would be seeking to avoid.... The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.

Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September 2001, the federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years. We were able to be unusually aggressive in the initial stages of the recession of 2001 because both inflation and inflation expectations were low and stable. We thought we needed to be, and could be, forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided for the first time in forty years.

There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession--even milder than that of a decade earlier. As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability...

Greenspan is confident that raising interest rates and thus raising the unemployment rate during the bubble of the late 1990s would have been the wrong policy, and that aggressively lowering interest rates after the bubble was the right policy. Lowering interest rates cushioned falls in bond prices. Lowering interest rates made use of bond financing for investment more attractive. Lowering interest rates boosted bond and real estate prices, induced households to refinance, and so provided a powerful spur to consumption spending that largely offset the post-bubble fall in investment spending. In Greenspan's view, the aggressive lowering ofinterest rates was exactly the right thing to do in the aftermath of the bubble to shift spending from investment to consumption and so to keep the economy not far from full employment.

Mussa says: not so fast. Very low interest rates, coupled with assurances from high Federal Reserve officials that interest rates will stay very low for substantial periods of time, produce a situation in which the prices of long-duration assets--long-term bonds, growth stocks, and real estate--climb very high. What goes up may come down, and may come down rapidly. And should some class of asset prices come down rapidly and should it turn out that many debtors in the economy go bankrupt because their assets have lost value, serious financial crisis will result. The price of using exceptionally easy money to keep the collapse of the dot-com bubble from turning into a depression has been the creation of a three-fold vulnerability:

  1. If the assets the prices of which collapse when interest rates start to rise are emerging-market debt, then the memories of the 1990s and increasing risk will induce large-scale capital flight from the periphery to the core--an echo of the East Asian financial crises of 1997-1998.
  2. If the assets the prices of which threaten collapse when interest rates start to rise are domestic bond and real estate holdings that have been pushed to unsustainable levels by positive-feedback "bubble" buying, then the "monetary authority would... confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing" to keep real estate and bond prices from falling far and fast.
  3. "If monetary policy is tightened too much too soon" (presumably because of fears of positive-feedback "bubble" buying), the result may be a credit crunch and a recession--with no guarantee that a reversal of the monetary policy tightening will undue the effects of the credit crunch.

I do not believe that many economists would say that Mussa's fears about the potential macroeconomic vulnerabilities created by the low interest-rate policy the Federal Reserve has pursued since the end of the dot-com bubble are unreasonable. (Few, however, carry their alarm to the degree that Stephen Roach of Morgan Stanley does.) And Mussa expresses them in a coherent language--one in which sustained rises in asset prices induce positive-feedback trading that "bubbles" prices above fundamentals, one in which what goes up comes down rapidly, one in which large sudden falls in asset prices produce chains of bankruptcy and raise risk and default premia enough to threaten to cause deep recessions. The language has echoes of the great Charles P. Kindleberger's (1978) Manias, Panics, and Crashes (New York: Basic Books), and of earlier writings about the consequences of excessive money-printing: "inflation, revulsion, and discredit."

But what Mussa's assessment of risks lacks is a model. And without a model, we have a hard time assessing his argument. Alan Greenspan frightened away the Evil Depression Fairy in 2000-2002 by promising not that he would let the Evil Fairy marry his daughter but by promising high asset prices--unsustainably high asset prices--for a while. Whether this was a good trade or not depends on the relative values of the risks avoided and the risks accepted. And to evaluate this requires a model of some sort.


References

Alan Greenspan (2004), "Risk and Uncertainty in Monetary Policy" (Washington: Federal Reserve Board: January 3).

Michael Mussa (2004), "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" (Washington: Institute for International Economics: April 1)

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Comments

But AG did raise interest rates at the end of the bubble before he drastically lowered them. And AG was too slow in lowering the rates. Had AG just left interest rates alone without all those hikes, the dotbust still would have occurred but without the damage to the rest of the economy and the ensuing overcompensation.

Posted by: bakho on April 20, 2004 10:01 PM

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"And to evaluate this requires a model of some sort." A model would indeed be nice. But models that do a convincing job of explaining/understanding the dynamics of asset price bubbles are hard to come by. The most common model - the rational asset price bubble - implies that the expected excess return from investing in the asset is zero. But it is hard to see why people are falling over each other to invest in assets -- which they seem to do in the rising phase of a bubble -- if they understand that the expected excess return from investing is zero. So you need a model in which people are systematically over-optimistic for some time, and then you need to understand why/how that is influenced by an extended period of very low interest rates.

Posted by: David Gruen on April 21, 2004 01:01 AM

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"to evaluate this requires a model of some sort." Yes please!

Posted by: Mats on April 21, 2004 01:25 AM

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Part VI? Why not Part 32,000?

Posted by: James on April 21, 2004 01:46 AM

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Your model will need to include an analysis of the change in the risk premium and a discussion of why the economic-financial system has become more stable over the last quarter of a century
-- the probability of recessions and bear markets has fallen significantly over this period.

Posted by: spencer on April 21, 2004 04:57 AM

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Need for a model. As in mathematical model? Is the request here essentially one so that we can make predictions/forcasts with some beefed-up confidence? (Strikes me as a move to inject some hard Science into this soft spot of economics).
Surely this task is monumental compared with the one of figuring out what might happen in this one particular case. The model is our tool box for all cases, no?
When Roach asks for an immediate 2% rate increase, his model ( or dart board?) says the economy can stand it. He implies that the other model(ers) are mistaken. Or is he (like Greenspan) just talking ( from considerable experience)?

Posted by: calmo on April 21, 2004 08:08 AM

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O.K., guys, here's how I see it: our current low-interest rate, easy money policy is indeed the proper one, and the asset bubble it has caused is quite real. The answer, however, is not to cut back on the printing presses at the first signs of inflation, which would indeed cause all the untoward consequences alluded to. Rather, the best policy is to continue expanding the money supply at about the same rate even as inflation picks up. This will cause nominal interest rates to rise substantially, but not nearly so much as real interest rates (equals nominal rate minus inflation rate) which is the real number to keep our eye on. Two favorable consequences of this scenario are easy to identify. First, the value of the dollar vis-a-vis our major trading partners will decline significantly, which will make imports more expensive and our exports cheaper, thus helping to close the absurd imbalance in jour national accounts. And second, a higher inflation rate (in the 3 to 5 percent range) will impact real wages throughout the American economy in a reasonably short period of time (1 to 2 years), which means that American corporations will find the prospect of investing in new plant and equipment to employ these workers (above all in expanding export industries) much more attractive than presently. In other words, we will have a solution to our jobless recovery.

On the downside, the wages of American workers will have taken yet another hit on top of the numerous ones that have been hammering them down since the early 1970s, hastening the day when a new populism and a new liberalism for the common man will have its day. It will be the end of the Republican party and the beginning of a new kind of Democratic party, and a chance for new men with new ideas.

Is that substantial enough for you Brad?

Posted by: Luke Lea on April 21, 2004 11:20 AM

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Good luck with the V remaining sections.

It seems to me that in the 1st part of this paper, Olivier Blanchard is grappling with the same issue:

http://econ-www.mit.edu/faculty/download_pdf.php?id=793

Posted by: P O'Neill on April 21, 2004 11:35 AM

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Inflation would only help if China & India would leave the dollar peg. Otherwise the only thing what happen is worldwide inflation.

Posted by: carl on April 21, 2004 01:55 PM

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Mussa says "Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada.... The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness."

I'm not a PhD in economics, but I always assumed "easy" monetary policy meant a rapid (defn. of rapid: more rapid than previously) increase in the money supply. Looking at a chart of growth of M3 dating back 44 years, it's absolutely not clear that M3 has been growing at a more rapid pace than during many periods of that time frame. In fact, for the last couple of years, the 20 week moving average of the rate of growth of M3 has been falling.

Posted by: GAB on April 21, 2004 02:43 PM

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Gab, The money supply is hard to measure because we keep inventing new forms of credit. So the better approach is to watch prices, in my opinion, and modify open market operations accordingly. Sort of like driving in a fog by watching the yellow line.

Posted by: Luke Lea on April 21, 2004 06:33 PM

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Luke, there is the view that despite the "awsome" productivity (Greenspan's remarks yesterday on why we can keep interest rates low), consumers still have to find a way to pay for these products.
So watching the price index rise .5% ( today's Bloomberg) means this task just got harder. So we should expect similar increases in foreclosure rates. Unless the consumer gets more tax relief or the interest rates decline(!) and last summer's refi performance is repeated, it is hard to see where the consumer is going to find the money. It is not going to come from the "awsome productivity". Some of us are not placated by Mr. Greenspan.
http://www.prudentbear.com/archive_home_com.asp?cate

Posted by: calmo on April 22, 2004 08:25 AM

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Like others here, I'm still anxiously awaiting your "model," Brad. In the meantime I keep handy Galbraith's THE GREAT CRASH -- 1929 as a ready-reference "word model." I also keep handy the mess Japan has recently been through, along with other stories of bubbles and aftermaths, as we keep pushing messes around the globe.

I know that when great cycles in history repeat, there are major differences due to the particulars of any current moment in history, contingency, path-dependency, etc. But there are similarities as well.

Building on Galbraith's expose of the deep-seated nature of people's attraction to bubble mania, and their deep-seated revulsion to risk in the aftermath of bubbles -- irrational pessimism -- I still think that finnessing our way through this is going to be extremely dicey.

I'm not optimistic that we will get this under control via US policy finesse, since we have failed to ward off the worst of the speculative frenzy in early bubble moments, e.g.1995-1997.

P.O'Neill's earlier post here referenced Olivier Blanchard's call for a mixed governental policy targeting "investment" as well as "inflation." I'd like to know what others think of Blanchard's work. It argues, in essence, that there are times when the government ought to take the punch bowl away...

http://econ-www.mit.edu/faculty/download_pdf.php?id=793

Posted by: dabbler dave on April 22, 2004 11:00 AM

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Doug Noland sums it our current mess up well in his April 16th Credit Bubble Bulletin. Here are a few of his key points, followed by his thoughts titled “Tightening Lite.” I believe that the way out, should one be found this side of massive war, will be yet-another international accord convened in the wake of global financial meltdown, this time hopefully with input from the likes of Paul Davidson, among others...

http://www.prudentbear.com/archive_comm_article.asp?category=Credit+Bubble+Bulletin&content_idx=31934
{Note: when you get to this site, scroll down for Noland's complete article..}

Doug Noland’s 4/16/04 Points to Ponder:

-- The Fed today faces a massive and endemic U.S. Credit Bubble unlike anything that existed during 1994. Worse yet, it’s gone global.

-- Thus, it is reasonable to assume that the Fed will approach this rate-tightening cycle with extreme caution – extra-soft kid gloves and ultra-baby steps. They will surely err on the side of waiting and watching. And when they do move, I would not be surprised if the Fed attempts to signal to the markets their intention of implementing some type of a cap on how high the Fed intends to move rates. Extraordinary effort will be taken to avoid the 1994 dilemma where the de-leveraging bond market was forcing the Fed’s hand – each rate hike had the marketplace seemingly discounting only more tightening and the Fed, perceivably, always lagging the markets. Governor Bernanke and others would today love to implement an “inflation targeting” monetary mechanism that would allow the Fed to signal the need to increase rates – in the context of the current inflation rate – perhaps in the range of 2% to 2.5%. I expect the Fed to go to extraordinary measures to appease the leverage players, with the specific purpose of avoiding a 1994-style de-leveraging. The Fed’s goal will be Tightening Lite

-- Tightening Lite is just not going to cut it. There are historic financial excesses and economic distortions that require tough medicine. Gradualism from the Fed will only prolong this most dangerous “terminal” phase of Credit Bubble excess. … two key issues are extreme Credit Availability and Bubble Dynamics, and both are likely immune to a few “baby steps” from the Fed.

-- Bubble dynamics are powerful, and this is specifically why it is imperative for central banks to be vigilant. They must be on guard and determined to quash Bubbles early, and they must be resolved to avoid “falling behind the curve.” Our Fed has failed miserably on both counts, and there will be a high cost to pay.

-- And an over-liquefied global financial system – if sustained – would continue to provide a powerful counterbalance to Chinese authorities’ efforts to rein in their historic boom. Again, Bubble dynamics are powerful and we are in the midst of a global Credit Bubble unlike anything previously experienced. It is no coincidence that the historic American and Chinese booms run concurrently, a dynamic that will now further complicate and already complex dilemma for respective monetary authorities.

-- There is a view today that the hedge funds have fueled Bubbles throughout various commodity markets, leaving commodities especially vulnerable to a major bust in the event of tightening global liquidity conditions. Such thinking may certainly have merit. However, I recall (and was sympathetic to) similar analysis going back a decade to when the hedge funds were taking large leveraged positions in the bond market. Well, speculators became only more enamored with bonds each passing year.

-- My hunch is that speculative interest, having returned to commodities after a long hiatus, will not prove a flash in the pan. And, importantly, the size of the global pool of speculative finance has absolutely mushroomed over the past decade. I expect many commodities will only become more enticing over time, as the dollar and currencies devalue and financial asset prices decline. At the same time, I fully expect that wild volatility is here to stay – Markets Governed by The Law of the Jungle.

-- We can, as well, look to the economies and housing markets in England and Australia for evidence as to the resiliency of Bubbles to moderate interest rate increases. If Credit is easily available, somewhat higher rates will not dissuade eager borrowers – especially when borrowing to acquire rapidly appreciating assets!

-- … I am essentially to the point where I will assume that nothing short of financial crisis will interrupt this inflation. Sure, currency markets will be prone to violent moves and the type of erratic ebb and flow associated with indecision and aggressive speculative trading. Especially with the massive amount of hedging taking place these days, we should not be surprised if these “ebbs and flows” are at time astonishing.

-- I could be wrong on all this. Perhaps the Fed can succeed in tempering Credit and speculative excess just enough without precipitating the bursting of myriad Bubbles (bond market, equities, mortgage finance, housing construction, general economy, etc.). I just don’t see how it’s possible. And I fully expect the Fed to err on the side of caution – Tightening Lite. Yet Tightening Lite is not tightening at all. Rather, it is really only more of the same – easy money and the wholesale acquiescence of lending excess, leveraging, asset inflation and endemic financial speculation. Being so far behind the curve and staring unprecedented risk eye-to-eye, it’s going to take some real guts and determination to rein things in. I’ll believe it when I see it.
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Posted by: dabbler dave on April 22, 2004 01:38 PM

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There's a big player - the elephant in the living room so to speak - regarding this whole business. As a matter of fact, the Fed does have more than one policy instrument. And certainly the Federal government has more than one policy instrument besides the Fed Funds rate.

Greenspan could have eased the bubble bursting by simply raising margin requirements. He could have also promoted tighter lending standards. Indeed a good monetary policy argument is that lending standards should be tightened or loosened in inverse relationship to credit easing and tightening.

It wasn't that there was just - and still is - a lot of money floating around. It's that it was finding it's way into a lot of speculation or floating enterprises that should have gone under. Macro-economic money supply is determined not just by transactions but by the quality of transactions. Dead money so to speak breeds no capital investment profits.

It's the same problem that happened in Japan only more severely so. Part of the problem of the JCB easing to near zero interest rate levels is that the money only prolonged the existence of zombie companies and kept banks from clearing bad loans off their portfolio.

Macroeconomic stimulus through monetary policy requires lending discipline, or else the stimulus does not achieve its Keynesian aim.

Greenspan himself has recently spoken out about the lack of accountability in the market system. Accounting standards, Corporate governance, institutional firewalls against conflicts of interest, tax system reform - all of these are tools to fight bubbles.

Similarly in a period of credit tightening, loosening credit standards can counteract or mitigate an otherwise harsh economic dampening. Recently the IRS spokesperson said that part of the reason why the 90's binge could happen is that the IRS takes about five years to do a complex corporate audit, and they simply hadn't gotten around to auditing the companies in question before they went belly-up circa 2000. They were still auditing 1995 forms.

Right now we have a system that essentially allows the loosening of credit standards at the same time monetary policy is eased or stimulus applied. This inevitably creates a rampant bubble - asset, debt, real estate, whatever, it's clearly speculative.

By using both policy instrument sets and trading them off against each other, both maximal stimulus and maximal inflation combating can be achieved in a more optimal Keynesian management of the short-term transitions in a national economy.

Posted by: Oldman on April 22, 2004 02:23 PM

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One comment above was really great. Why did AG raise rates first of all if only to lower them later on? Keep 'em low, yes, constantly, and the boom could go on forever. Oh' poor Al, why the heck did he not know THAT? I wish there were more comments like that. I gues soon we'll see a post suggesting negative policy interest rates. That would be great. What lovely country the US is. The land of unlimited possiblities.
Antony

Posted by: antony mueller on April 23, 2004 09:02 PM

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One comment above was really great. Why did AG raise rates first of all if only to lower them later on? Keep 'em low, yes, constantly, and the boom could go on forever. Oh' poor Al, why the heck did he not know THAT? I wish there were more comments like that. I gues soon we'll see a post suggesting negative policy interest rates. That would be great. What lovely country the US is. The land of unlimited possiblities.
Antony

Posted by: antony mueller on April 23, 2004 09:02 PM

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One comment above was really great. Why did AG raise rates first of all if only to lower them later on? Keep 'em low, yes, constantly, and the boom could go on forever. Oh' poor Al, why the heck did he not know THAT? I wish there were more comments like that. I gues soon we'll see a post suggesting negative policy interest rates. That would be great. What lovely country the US is. The land of unlimited possiblities.
Antony

Posted by: antony mueller on April 23, 2004 09:03 PM

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One comment above was really great. Why did AG raise rates first of all if only to lower them later on? Keep 'em low, yes, constantly, and the boom could go on forever. Oh' poor Al, why the heck did he not know THAT? I wish there were more comments like that. I gues soon we'll see a post suggesting negative policy interest rates. That would be great. What lovely country the US is. The land of unlimited possiblities.
Antony

Posted by: antony mueller on April 23, 2004 09:03 PM

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One comment above was really great. Why did AG raise rates first of all if only to lower them later on? Keep 'em low, yes, constantly, and the boom could go on forever. Oh' poor Al, why the heck did he not know THAT? I wish there were more comments like that. I gues soon we'll see a post suggesting negative policy interest rates. That would be great. What lovely country the US is. The land of unlimited possiblities.
Antony

Posted by: antony mueller on April 23, 2004 09:03 PM

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One comment above was really great. Why did AG raise rates first of all if only to lower them later on? Keep 'em low, yes, constantly, and the boom could go on forever. Oh' poor Al, why the heck did he not know THAT? I wish there were more comments like that. I gues soon we'll see a post suggesting negative policy interest rates. That would be great. What lovely country the US is. The land of unlimited possiblities.
Antony

Posted by: antony mueller on April 23, 2004 09:03 PM

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Very low interest rates, coupled with assurances from high Federal Reserve officials that interest rates will stay very low for substantial periods of time, produce a situation in which the prices of long-duration assets--long-term bonds, growth stocks, and real estate--climb very high.

Brad, your right, better to hang these bastards, who borrowed betting on such price increases, on a cross of gold.

Economic policy should be reversed. The only mission of the fed should be to keep interest rates at current low levels. Increasing the interest rate is the ultimate bailout for the rich, who profit without risk.

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