Old Growth Forest

Fire, Man's Reliable Solution!  

Fire is a natural part of a forest's life.  However, we used to believe that fires always need to be put out.  This led to old growth forests that were even more prone to fires because they had dead wood strewn throughout.  Nowadays, we realize that fires should occasionally even be set in order to reduce the severity of natural forest fires and to permit better growth of the forests.

This anecdote fits our current monetary policy perfectly.  When the economy begins to dip into recession, interest rates are cut.  This has the effect of cheapening money.  Anyone that has a credit card knows that lower interest rates mean charge it!  After the terrorist attacks of September 11th, the interest rate dropped so low that it helped to cause the housing bubble.  The economy exploded on this cheap money, fueled in part by the same reasoning that has us reaching into our pockets for the credit card with the lowest interest rate.  

Now let's engage in a thought experiment.  (Thought experiments are better because you can have have explosions in them that don't create any damage, and there will be an explosion in the following thought experiment!)

Imagine that you've been on a speeding spree, due in no small part to your low interest credit card.  And after charging and charging, you've started to accumulate too much debt.  The mail is delivered one day with the bad news.  The low, low rate has now been raised by a couple of percentage points!!!  Oh, expletive deleted!  Ka-boom, you explode and set fire to everything in the house (Thank God, it's a thought experiment).  After you settle back down what happens?  Do you go out and keep on spending with the same cavalier attitude?  Heck no!  You may even start budgeting.  

But what does old growth forest have to do with anything?  It has everything to do with how our central bankers only put out fires.  If anything slowed down the economy, they would cut interest rates.  The economy would heat up and catch a bubble (dotcom bubble, housing bubble).  But the central bank would not do anything to reduce the impact of the next fire.

No small controlled fires were set to prevent catastrophe.  Greenspan would simply utter terms like "irrational exuberance," or "froth", and then go back to impressing Andrea Mitchell, probably.  He didn't raise rates to calm things down.   The credit card example above illustrated how to stop people from spending before they were too deep in debt.  Greenspan waited with firm belief in a policy doctrine that enjoyed widespread support: there can be no bubbles in stock prices because the market reflects all relevant information and are therefore efficient.  

More on this in: Santa, the Easter Bunny, and the Efficient Market Hypothesis.