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Friday, June 23, 2006

Fighting Yesterday's Economic War

Robert Reich says policymakers tend to overreact to the potential for a rerun of the worst economic event in their lifetimes. Because of this tendency, the current Fed is overly sensitive to inflation and to a repeat of the 1970s. In fact, he says, the Fed should be worried about deflation, not inflation:

The Real “Flation” Threat, by Robert Reich, American Prospect: Each generation responds to its own traumatic memory. Ben Bernanke and his Federal Reserve remember the double-digit inflation of the 1970s and are determined to mount a preemptive strike. That’s why they’re poised on raising interest rates yet again Bernanke and company have no direct memory of the trauma that haunted the previous generation, the depression of the 1930s.

Each generation, in its determination to avoid the nightmare it does remember, runs the danger of over-reacting, and thereby bringing on the opposite trauma. A generation ago, economic policy makers paid too little attention to inflationary forces then building in the American economy. Eventually, Paul Volcker had to break the back of inflation by raising interest rates sky high. That put the economy into a severe recession. Now Bernanke and company are paying too little attention to deflationary forces building in America and the global economy.

Bernanke fears that today’s economy resembles the one that began to overheat the 1970s. But he’s wrong. ... Bernanke and company worry the U.S. labor market is heating up. They’re wrong here, too. ...

If anything, there’s too much capacity relative to demand. This is a recipe for deflation. Prices can begin to drop because buyers hold off, expecting further price decreases. It happened in Japan in the 1990s. It’s already starting to happen in certain housing markets in the United States...

The Fed and other central bankers around the world are raising interest rates because they’re fighting the last war. But they already won that war. Inflation is no longer our biggest threat. They ought to be worried about the war before the last one, and the specter of deflation. They’re in danger of losing that war even before they know they're in it.

I think I'll put Reich in the "sees the potential for a hard-landing" group.

Update: It occurred to me after I posted this that I should have mentioned Ben Bernanke's Views Affected by Depression.

    Posted by on Friday, June 23, 2006 at 12:52 AM in Economics, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (41)


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