Martin Feldstein is worried

Martin Feldstein wants to cut US interest rates by one percent. I agree with him for all the reasons that he puts. And disagree with the opponents of a rate cut for the main reason he does. The idea of a ‘Greenspan put’ is pretty silly when the put, or the implicit guarantee, is to ‘the market’ or ‘the economy’ and does not bail out people who have made stupid decisions. For everyone for whom it moderates the losses of stupid decisions it saves one or more people who made perfectly good decisions and are now going broke because of contagion and the difficulty of raising credit.

Anyway, Martin Feldstein is a lot smarter than me. He’s even a lot smarter than Brad Delong – according to Brad Delong. So here’s what Martin Feldstein says.

Liquidity Now!, by Martin Feldstein, Commentary, WSJ: The time has come for the Federal Reserve to cut the federal funds interest rate substantially, starting on a path from the current 5.25% to 4.25% and possibly even less. Without such a policy shift, the U.S. economy faces the risk of a significant economic downturn.

Three separate but related forces are now threatening economic activity: a credit market crisis, a decline in house prices and home building, and a reduction in consumer spending. These developments compound the general weakening of the economy earlier in the year, marked by slowing employment growth and declining real spendable incomes. …

Fed action to lower interest rates cannot solve the credit market problems, but it would help the economy: by stimulating the demand for housing, autos and other consumer durables; by encouraging a more competitive dollar to stimulate increased net exports; by raising share prices to increase both business investment and consumer spending; and by freeing up spendable cash for homeowners with adjustable-rate mortgages.

A reduction of the federal funds rate would not be a bailout for individual borrowers and lenders who are suffering from their past mistakes. Any such targeted bailout would be wrong, encouraging more reckless behavior in the future. But it would also be a mistake to resist an interest rate cut and risk a serious economic downturn merely to avoid the indirect effect of helping those market participants. …

Although the extent of the possible decline in economic activity is uncertain, the economy could suffer a very serious downturn if the triple threat from the credit market, housing construction, and consumer spending materializes with full force. A sharp reduction in the interest rate would attenuate that very bad outcome. …

Setting the federal funds rate requires a balancing of risks. If the economy would have continued to expand in the absence of a large rate cut, Fed easing now would produce an unwanted rise in inflation, an unwelcome outcome but the lesser of two evils. If that happens, the Fed would have to engineer a longer period of slow growth to achieve price stability. The economic cost of reducing that inflation would depend on the Fed’s ability to persuade the market that easing under current conditions is an appropriate risk-based strategy and not an abrogation of its fundamental duty to pursue price stability.

Should we cut rates in Australia? I don’t think so at least now, even though liquidity is driving up the cost of borrowing beyond the recent rise in the cash rate, but I’m not sure why they’re waiting around in the US. They seem caught up in the atmospherics of not panicking, not being seen to bail the market out etc etc. But their economy needs a rate cut so lets get on with it, and lets make it a decent one.

To borrow some very pithy words from our own Central Bank Gov’nor, its hard to find the words with which to explain why you wouldn’t do what appears to be appropriate. That’s what all that independence is for.

This entry was posted in Economics and public policy, Politics - international. Bookmark the permalink.
Notify of

Newest Most Voted
Inline Feedbacks
View all comments
16 years ago

What’s astonishing, Nic is how the US stock market is still holding up so well. If the stock market is supposed to be a pointer to recession, it’s certainly not showing it yet. Why not? That has me beat.

There has been fed speak galore in the past 48 hours with various Fed governors offering their “valued” opinions about all sorts of things.

Bernanke made what i thought was a staggering silly comment for a fed governor proving once again that Uncle Al is a person who will be missed.

This is what he said:

the large US current account deficit cannot persist indefinitely because the ability of the United States to make debt service payments and the willingness of foreigners to hold US assets in their portfolios is limited.

Two problems with this.

1. Does he want to create a stampede out of the dollar once he starts lowering rates?

2. Why is he higlighting the trade deficit if he needs foreigners to finance it while telling them not to be the last elephant out of the key hole.

As for the other chattering Fed board members, it seems there isn’t the urgency in their voices or that they understand the gravity of the problem.

They will cut on the 18th, but the dollar seems gone for all money.

16 years ago

What’s the evidence for credit contagion? Do you just keep printing money forever and hope that every works out? Do you just keep on borrowing money from China, Saudia Arabia et al. ? It seems to me that we’ve had years of asset price inflation which people were only too happy to have, and now we’re simply coming back to something more sustainable, which unfortunately comes with a hang-over.

JC: You’re such an optimist — I really don’t think it matters if he highlights the trade deficit or not. I’m sure the people owed the trillions of dollars are quite aware of it and want a decent return. I also doubt that the people owed the money really care if the US goes into stagflation because of it.

Uncle Milton
Uncle Milton
16 years ago

Bernanke made his reputation more thsn 20 years ago with his research on how the drying up of credit markets made the Great Depression much worse, so it’s likely he is aware of the problem.

Cutting rates is what is needed, but the psychology of the market is very fragile, and cutting them by one per cent in one go would smack of panic by the Fed, and lead people to think that they know something really, really bad is about to happen. Then we’d get panic selling of everything, liquidity would dry up even more and we’d have a real crisis.

Slow and steady is the way to fix the problem and manage te market psychology.

16 years ago


The US has been running an uninterupted trade deficit since 1975. Thats’s over 30 years! The US has run a trade deficit for a good part of it’s life.

If Helicopter Ben had bothered the read last month’s TIC data he would have seen that it wasn’t private investors that financed the short fall, it was governments from around the world. You don’t want this to be a trend!

The worst thing you can do is highlight your weaknesses to the private market who are really just a bunch of chicken littles. Uncle Al would never have done that!

The problem with Helicopter Ben is that he has no market experience compared to Al.

Trade deficits don’t really matter all that much as long as you are able to finance them and so they’re only a problem when they beocome a problem and not one moment sooner.

There is all sorts of damage a Fed governor can cause by saying this, the wrost of which is higher bond rates at a time when the credit spread is widening and risk appetite jaws and closing.

Someone should tell Heli Ben that you don’t try to run when your pants are down to your ankles!

16 years ago

JC: I agree with you about trade deficits (and government deficits for that matter) — my concern is more over whether anyone has any will power to actually do something about them before they get to a level where they really are a problem. I’m not sure that reducing interest rates is exactly conducive to this, unless it helps export industries versus speculation.

16 years ago


look the fact is that the US needs to clean up the books after years of mal-investments, so if were up to me i’d leave interest rates alone for a while and see where the cards fall.

The other really good trhing they could do is lower the discount rate at the window and see what happens.

the best thing may be to allow the recession to run its course and do nothing.

16 years ago

Little house on the praire it isn’t. Little house in LA it is. Businessweek did a history of a house going back to 1994

Christopher Palmeri of
Businessweek has written of the “life” of a very small
house in Los Angeles’ Hancock Park neighbourhood. The
house, built in 1921 is but 1300 square feet, and is recent
history is as follows:
July, 1994: A couple purchases the house for
$23,000, borrowing $218,000 at 6.75% from Jon
Douglas Finance.
March, 2003; The refinance, borrowing $313,000
from the Downey Savings & Loan at an
adjustable rate starting at 3.5%.
July, 2005: They sell to a flipper for $815,000.
He borrows $570,000 from Loan Center of
California at 6.75% and an additional $244,000
from the same lender. He spends $115,000 on
March, 2006: The house is sold for $1.29
million. The buyer borrows just over $1 million
from First Franklin, now a unit of Merrill Lynch at
7.5% and an additional $259,000 from the same
August, 2007: On behalf of mortgage investors,
the house is foreclosed on. It is listed by Re/Max
at $900,000. Broker Kenneth Davis says an offer
has been accepted at “close to asking.

Fred Argy
Fred Argy
16 years ago

Nicholas, a timely piece.

Policy makers are facing a nightmare balance of risks – a serious economic downturn versus an increase in inflationary pressures. When in such a situation, central banks need to find a middle of the road compromise. This suggests a decrease of 0.5 percentage points in the Federal funds rate. If it went as far as a 1 percentage point reduction, the Bank could lose all its hard-won credibility on inflation. I am not a hard liner on inflation at all but it has been a long bloody battle to get inflationary expectations down. We cannot capitulate now.