The Fed has kept interest rates at an historic low in an attempt to help 'heal' the economy. Fed Governors have no fear of dead weight in assets, in the form of declining values and poor potential returns. The assumption is that with economic expectations so low, inflation is not a risk, and that rates can be used to 'fix' things by keeping rates low indefinitely.
This artificial approach to soothing our economic woes is a dangerous game. The economy has, in many respects, become unlinked from the stock market. In pursuing the current path, the Fed has gambled on some concepts which have been tried before, though in different conditions and with varying results.
Does this sound familiar? Because if it doesn't, remember that the current situation was caused, in part, by the creation of bundled mortgages, an existing tool which was utilized to try something new, with the assumption of safety baked in. In theory, the level of risk was limited. The problem with them was related to the nature of the individual loans themselves. Each bundled group offered had varying degrees of risk involved. Despite the levels of risk, many high risk assets were given very good ratings. In the end some failed, which put all at risk.
The issue the Fed faces is not a simple one, though they seem to approach it as if it is. To the Fed, keeping rates low and purchasing assets to keep the system liquid will offset any further damage to overall economic conditions. Things do seem to have stabilized, so there are varying degrees of opinions about how successful the strategy has been. The difficulty of saying whether or not it has been successful is that expectations for this approach were so much higher. In normal conditions, the economy should be booming. Instead, only the stock market is. What the Fed may not realize is the cure may be as dangerous as the illness, especially since one part of the cure has been a massive increase in 'crony capitalism', which has been codified by the Too Big To Fail policy. In addition, the Fed finds itself competing with investors rather than assisting them.
To get at the root of the issue, we have to look at Economics as a science. While other sciences have limited inputs, and can thus be relatively reliable as forecasting tools in experimentation, Economics has far too many inputs. In addition, there is no lab in which to test those inputs. Instead, the 'testing' is done in real time.
Economics often faces the conundrum described by Schrodinger's Cat. Checking on results alters the potential outcome. In collecting data for discussion, people tend to come to different opinions about what the data mean. So each person prepares and reacts a bit differently. Thus, a booming market tells some people the good times will continue, while it tells others to prepare for the bust. Eventually one side wins out, and the results with each iteration change, making predicitable outcomes unlikely.
Science is meant to explain, and predictive qualities are a sidelight. Economics is very good at explaining. For the most part, we know how and why certain events occurred in the course of our economic history. While economists may quibble over policy and details, the larger mechanics of the market are fairly well understood. But markets have a sensitive dependence on initial conditions, another way of stating the more commonly known 'butterfly effect'. Thus, details matter and the predictive capabilities of economics is limited.
Generally, economists know why the economy is in bad shape. The problem is that few know exactly what to do about it. Some, like Krugman, feel we need to spend more at the government level. Others feel it is enough to just leave business alone, as Bastiat would suggest. Still others feel we simply don't understand enough about how things work to make decent policy decisions.
I'm of the 'don't understand enough' school. In essence, the 'solution' this school suggests is to limit the impact of human intervention. That is, reduce government inputs, limit the impact of human interaction (like the Fed), and let people make decisions based on the things that impact them directly, allow markets to just do what they do without government policy impacting them. Like it or not, bond sales of government debt, even to the Fed, play a role in altering how the market operates.
In normal conditions, as the market was melting down and liquidity was drying up, interest rates would have risen. This would have increased savings and improved liquidity. In the short run, we'd have suffered terribly. You can be relatively sure that whatever we experienced was mild compared to what may have occurred. However, we wouldn't have fallen into a negative feedback loop that would have taken us ever deeper, as many on the Left suggest. No, the basis of interest rates would've been to increase liquidity naturally, and the economy would've turned around. It definitely would've taken some time, but by now we likely would be out of it.
This is my view, it's purely hypothetical, but previous situations in which the government did little (such as the 1921 depression) give some support to its effectiveness.
If we look at one of the primary causes of the collapse, the clearest single source is the Fed itself. From 2001 until 2004, interest rates were at all time lows. This caused a bubble in real estate, such that by 2007 interest rates were high again, having gone up by 200% in only 3 years. Within a year of 2007, interest rates were again at historic lows and falling. Today they are even lower. All things considered, we should be in the middle of one of the largest economic booms ever. But we are not.
Few have stopped to consider that the solution being applied is the original cause in the first place - artificially low rates. People are not being asked to save, they are being encouraged to borrow at a point in time when economic conditions suggest saving is the correct response. We have seen savings rates rise, primarily because people are intelligent and don't just react to economic signals like interest rates. But we have also not seen borrowing fall, as would be expected if interest rates were allowed to rise.
I hope the good times last. But I am not optimistic. It's possible I am simply a pessimist and things are improving. Personally, I know I'm better off now than I was 2 years ago and even 10 years ago. But my personal situation isn't an indicator of things in general. I also know more underemployed and unemployed people than I did 2 years ago. I'm not sure politics will provide a solution, though it certainly is part of the overall equation.
The Fed is playing a dangerous game, and for now it's making people think times are good or getting better. The stock market is 10% from an all time high, people are finding jobs (though not nearly at the rate we're told by the BLS), and the cost of living remains manageable, primarily due to mortgage refinancings. But many items have increased in price, such as gasoline (150% higher than the depths of December 2008), while food and clothing have been rising faster than the average rate, as well.
At some point the excessive liquidity will enter the real economy, not just the stock market. When it does, then the real effects of the Fed's policies will become very evident.
