Monetary Theory and Policy
In today’s econtalk podcast, Tyler Cowen and Russ Roberts discuss monetary theory and monetary policy. It is a wide-ranging discussion, covering several weeks worth of an intermediate macro course. If you are not familiar with the subject, you might have to listen several times, and perhaps read up on some of the topics.
Regarding the current situation, Tyler’s view is that there is not much the Fed can do. The breaking of the house price bubble is what he calls a “real shock,” meaning that it is bound to lead to some higher unemployment. The Fed can try to mitigate the higher unemployment, but only at the cost of higher inflation.
My personal view is that the “real” effect of the end of the bubble in house prices is that people need to shift out of jobs that depended on a vigorous housing market (construction workers, real estate agents) and into other occupations, perhaps occupations associated with industries that export or that compete with imports–to take advantage of the weaker dollar. Of course, in our dynamic economy, it is always true that some sectors are contracting while others are expanding. So I don’t know how much additional difficulty is caused by the housing market problems. Note that we have gone through such a large drop in housing construction already, without even a one percentage point rise in the unemployment rate. One could argue that the “real” effect is nothing to worry about.
Instead, the last few days have seen worries about the financial sector, a topic which the podcast also touches on. Here, Tyler and I both would rather have Ben Bernanke dealing with the situation than anyone else. The challenge in the financial sector is that risk premiums are rising. As Jeff Frankel pointed out, this even affects the market for municipal bonds.
As I have discussed in recent posts, the market needs a speculator willing to hold risky assets for a while. Under Bernanke, the Fed is choosing to play that role. If he is right, then the Fed will earn a profit for the U.S. taxpayers in the long run, as well as stabilizing the financial sector in the short run. If he is wrong, and all of the mortgage-backed securities, municipal bonds, and such are going to default at much higher rates than expected….well, in that case, we’re in quite a pickle and any losses the Fed takes should be the least of our worries.