## Wednesday, January 30, 2008

### Why it was wrong to cut the rates

Eight days after the Big Ben lowered his defining interest rate by 0.75 percentage points, they subtracted extra 0.5 points, ending at 3.0%. The sum, 1.25 percentage points in 8 days, is unprecedented. Even after the 9/11/2001 attacks, the interest rates were only lowered by 0.5 percentage points.

The interest rates in the U.S. should have been higher by 3-5 percentage points during the last 5 years or so. Let me sketch several general reasons why it was wrong for the Fed to reduce the rates so rapidly and why it is generally bad for the Fed to maintain low rates and to allow the U.S. currency to weaken.

Regulators should regulate fluctuations

As we have discussed repeatedly, markets have the tendency to amplify various fluctuations. The herd mentality of the investors is one of the reasons. Such economic cycles may lead to crises. These things are natural but if they are excessive, they are unhealthy. If the central banks and federal bodies are supposed to do something, they should try to make the behavior of markets more constant, not more violent.

So they should act as a kind of negative feedback. They should never try to overreact. They shouldn't try to overcompensate an effect by another but stronger effect or amplify the overall havoc on the markets.

Now, most slowdowns are preceded by various unsustainable bubbles. In many cases, various equity prices grow faster than certain sustainable rates. While the growth may be trusted in the short run and many people earn cheap money from it, it is very clear that eventually, it must stop or collapse. The dot com bubble and the housing bubble of the last decade are two recent examples.

In my opinion, responsible officials should try to regulate these movements already when they are going up. They might want to say what prices and their time derivatives they consider reasonable and try to influence and calm down the psychology of the markets. Some price dynamics is clearly unsustainable. For example, if housing prices increase by 10 percent every year while wages only grow by 5 percent or less, it is not hard to see that houses are rapidly getting increasingly unaffordable. Constant affordability essentially means the same average growth of the housing prices and wages.

Still, it is not unusual that the housing prices sometimes increase by 10 percent for a couple of years. However, it is then obvious that these prices must sometimes also drop by comparable fractions. If the authorities didn't act to slow down the excessive increase of prices, they shouldn't act against their drop either. A further drop in housing prices by 20-50% is pretty much unavoidable and responsible people shouldn't pretend that it is not.

Now, a decreasing feeling of wealth surely reduces consumers' spending which might be considered a bad thing by some people. But the very same sentence also holds in the opposite direction. Increasing home prices are (or were) artificially increasing consumption above the rate that would exist if the housing prices were increasing sustainably. I feel that too many people want to see only one side of this coin (and many other similar coins). If they become financial government officials, they inevitably lead the economy to an unsustainable behavior that must obviously end up in amplified cycles and deeper crises.

Inflation and exchange rates are more robust measures of the proper value of money

Finally, all central banks look at inflation because inflation is always and everywhere a monetary phenomenon. The Federal Reserve in particular emphasizes the economic growth. It uses lower rates to stimulate it when the growth slows down. I think it is a wrong perspective.

While lower rates do stimulate the economy, they also lead, to one extent or another, to many other effects, including higher inflation, weakening currency, increasing spending, increasing debt. I think that the primary goal of the central banks should be to keep the value of money constant.

In the past, the value of money was determined by the gold standard, by the ultimate "constant" precious metal. However, gold doesn't play such an important role today. Neither does silver, the second candidate for a "prototype" of value. In fact, the gold/silver price ratio has been dramatically fluctuating during the last two centuries. A much more robust definition of the value of money involves all possible products that people buy.

The inflation rate measures how the value of money with respect to the basket of actual consumable things changes every year. This number should be kept more or less constant because price stability defines the equilibrium of supply and demand for money.

The GDP growth depends on many other things - for example the weather in agricultural countries - and there exists no principle that would dictate that this figure should be constant. Also, stock prices are derived quantities that determine the ability of companies to create values under certain (and changing) circumstances. Again, there is no a priori reason why these things should be constant. But a non-constant value of the money - with respect to things that people actually need - is simply a bad thing.

Irresponsible behavior should be punished

We have discussed the issue or moral hazard many times. Once again, irresponsible behavior must be punished. If someone takes a risk and makes a profit, it must also be possible that sometimes the risk works against the person and leads to a loss. If the government or the central banks save the speculators - both rich as well as poor ones - in such a way that the sign of the speculators' profit is always positive, it leads to increasing speculation, less stable markets, and less efficient markets where people effectively insured by the government earn cheap money for activities that are not useful for anyone (except for the person who makes the money).

The Fed shouldn't be a slave of the Wall Street. The decisions of the Federal Reserve influence many other types of people - such as U.S. students who must now pay a lot of money abroad. The bankers should be independent from all pressures of limited subgroups of the population or the economy.

Strong dollar policy is beneficial for the U.S.

The strong dollar policy has been a very good policy for the U.S. and if someone openly or secretly believes that it is not the case, he or she is extremely wrong.

First of all, a strong dollar has been one of the major reasons that is (or was) making American economy, science, and technology superior. A stronger currency means higher salaries - when converted to another currency - and higher salaries attract skilled workers and increase the competition. All these things increase productivity and related observables.

It is an effect that we also know from individual countries. For example, Prague is able to concentrate skillful, hard-working, smart people because it has a richer local economy than the rest of Czechia. The causal relationship goes in both ways. The local economy is strong because there are lots of hard-working people who have something to offer and they are there because the local economy is strong and offers them high salaries.

If the effect of concentrating people worth high salaries diminishes, the comparative strength of the city or the country diminishes, too. What do I want to say? For example, the U.S. still may have about 3 times higher salaries than the Czech Republic if measured by conversion (but 2 times as measured by the PPP). Will this ratio of 3 or 2 persist? I think that the answer is No unless the U.S. restores the strong dollar policy. If it doesn't, the average salaries in both countries will eventually coincide - just like the average IQs (98) and other objective quantities describing the economical environment in both countries coincide.

Once again, the currency strength has a profound impact on the attraction of brains and qualified workers in general. The competitive edge of a country largely depends on these things.

Moreover, America has a significant trade deficit. While it is true that a weaker currency could reduce it, it takes some time. In the short run and medium run, it is much easier to reduce it by a strengthening U.S. dollar simply because the imports become cheaper in the U.S. dollars and imports are more important for the overall calculation than exports because they are larger (because of the trade deficit).

I think that a weak currency significantly helps the trade balance only if the country already has a significant surplus (an example is or was China). For countries with a large trade deficit such as the U.S., a weak currency may make the balance even worse and the last 6 years demonstrate this fact pretty clearly.

On the other hand, there is nothing wrong about having a large trade deficit for many decades because the growth of the economy - and population - of different countries may simply differ for whole centuries. There would be nothing surprising about the U.S. economy growing, building, and importing more than the Japanese economy simply because there is more space in the U.S. for people, their houses, and their new companies.

I want to say one more thing: a strategic, political observation. Friends of the U.S. are much more likely to hold the U.S. dollars while the U.S. enemies have a much higher probability to bet against the U.S. currency. By weakening the currency, the Fed effectively helps the enemies of the U.S. financially while it punishes its friends. It is a very bad evolution for the American (and not only American) strategic interests.

Fast rate cuts create the feeling that something really serious is going on

Another observation is so obvious that I will only dedicate two sentences to it. Fast rate cuts create the impression that the U.S. economy is in a serious trouble and such an impression has the ability to transform itself into reality. Such a dramatic behavior repels all kinds of investors, especially the international investors who are influenced not only by the prices of U.S. stocks etc. denominated in the U.S. dollars but also by the value of the U.S. dollar.

Americans borrow easily and they need higher rates

Finally, America should have higher rates than many other countries simply because the Americans are clearly not shy to borrow money. After all, their self-confidence in borrowing money is one of the driving forces behind the trade deficit. This comment is another reason supporting the thesis that lower interest rates "help" to increase the trade deficit.

If I summarize, I think that the importance of one causal relationship - between interest rates and the stimulation of the economy - is being heavily overestimated because of some flawed, Keynesian thinking while many other, more important relationships and principles are being largely neglected. When you think about all these things, you will see that the bankers are creating at least as much damage as they help.

And that's the memo.