In this well-written post, Raghu Rajan argues that this is not the time to raise interest rates but at the same time argues that interest rates should also rise lest they result in speculative growth. However, I had a hard time parsing his arguments without resorting to some cutting and pasting to link together his argument.
Of course, some who are convinced that the Fed contributed to the recent crisis by keeping real interest rates negative too long in the period 2002 to 2004 would wonder if stimulus “consistent with the past” is appropriate. Has the Fed, like the Bourbons, learnt nothing and forgotten nothing?
... What many people forget is that interest rates are also a price, and shape not only the level of economic activity but also the allocation of resources and the relative wealth of buyers and sellers of financial savings. A sustained period of ultra-low interest rates will favor the segments of the economy that took us into the crisis – housing, durable goods like cars, and finance. And it will encourage households to borrow and spend rather than save.
... None of this is to say that the Fed should jack up interest rates quickly without adequate warning, or to extremely high levels. There are trade-offs here, between short-term growth and long-term misallocation of resources, between reducing risk aversion and inducing excessive risk taking, between reviving hard-hit sectors and encouraging repeated bad behavior. On balance though, if and when the jitters about Europe recede, it would be prudent for the Federal Reserve to start paving the way towards positive real interest rates.
Aha! So he is arguing that interest rates should rise. But what about fiscal policy?
Even while I think monetary policy is too a blunt tool, there may well be some role for fiscal policy. There is a humanitarian need to extend benefits to the unemployed.
Yes, but no.
I don't disagree with what he is saying but it doesn't say a heck of a lot about what we should do NOW. His arguments about labor reallocation however may point to some painful adjustments ahead:
If households are going to want fewer houses, industries such as construction will have to shrink (as should the financial sector that channeled the easy credit). A significant number of jobs will disappear permanently, and workers who know how to build houses or to sell them will have to learn new skills if they can. Put differently, the productive capacity of the economy has shrunk. Resources have to be reallocated into new sectors so that any recovery is robust, and not simply a resumption of the old unsustainable binge. The United States economy has to find new pathways for growth. And this will not necessarily be facilitated by ultra-low interest rates.