NOVEMBER
2005

 

By
Larry DeBoer
 
Professor of
Agricultural Economics
Purdue University

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11-23-05

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Speed Bumps and Bernanke


There's a speed bump in front of my house. It's painted with white stripes so drivers can see it. Just about everyone on the street signed a petition asking for this bump. Drivers were going too fast, and we feared for our children.

A speed bump is an odd thing. You would think that a well-paved road would be a safe road. No potholes to swerve around, just smooth driving. But no. To make the road safer, we made it bumpier.

We call it "moral hazard" in the economics biz. Sometimes government policies cause people to ignore or underestimate risk. A well-paved road convinces drivers that there is no danger, so they drive fast. And that's dangerous. We increase the very danger we want to prevent.

There's an example of moral hazard in New Orleans. The government will spend billions helping people rebuild their flood-damaged homes. Most of us agree that it's the right thing to do. But some people guessed that the government would do that, so they built homes in the flood plain. People ignored or underestimated the risk of flooding, and put themselves in harm's way.

Alan Greenspan, the long-time chair of the Federal Reserve, is going to retire at the end of January. He's been successful. Partly because of his policies, inflation has remained low, and gross domestic product has grown more steadily than at any time in U.S. history.

There may be moral hazard in that success. Greenspan pointed it out in a speech on Sept. 27. It's ironic, he said, that "success at stabilization carries its own risks. Monetary policy -- in fact, all economic policy -- to the extent that it is successful over a prolonged period, will reduce economic variability and, hence, perceived credit risk and interest rate term premiums." (You can find the speech on the Fed's Web site, at http://www.federalreserve.gov/boarddocs/speeches/2005)

Because the economy has been so stable, lenders and stock buyers underestimate risk. They lend at lower rates to more risky borrowers; they buy risky stocks at higher prices. But this makes the economy more vulnerable when something goes wrong. More borrowers will default. More stocks will crash.

President Bush has nominated Benjamin Bernanke to be Greenspan's successor. He seems sure to be confirmed by the Senate. Understandably, Bernanke has been keen to assure everyone that he will continue Greenspan's policies. Once he's in office, he'll want to nail that down by doing what Greenspan would have done.

The Fed has been raising interest rates gradually for a year and a half, trying to stop inflation before it starts. It's expected to keep at it for Greenspan's last two policy meetings, in mid-December and at the end of January. By then, the federal funds rate will be 4.5 percent. That's the interest rate that the Fed influences most directly.

The goal is a "neutral" federal funds rate, one that neither stimulates nor retards economic growth. Probably it's somewhere between 3.5 percent and 5.5 percent. By January, we'll be right in the middle of that range.

Then Bernanke takes over. Should he keep raising the rate, because that's what Greenspan was doing? That might assure the markets that he's a tough inflation-fighter in the Greenspan mold. Or it might scare the markets because they think Greenspan would have stopped at 4.5 percent. Should he stop raising the rate, because it's hit the neutral target, and Greenspan would have stopped? This might assure the markets that he's a savvy analyst of the economy's needs, in the Greenspan mold. Or it might convince the markets that he's soft on inflation.

Either way, it's possible that lenders and stock buyers will reconsider their ideas about risk. Maybe the new Fed chief won't be as talented as the last one. Maybe the economy won't be as stable. If the markets wake up to moral hazard, they might decide to lend less, at higher interest rates and to sell those risky stocks. This would slow the economy down.

Benjamin Bernanke may be the best-qualified person in America for the Fed job. But he isn't Alan Greenspan, and that just might make him a speed bump on our economic street.

 

 

Writer: Larry DeBoer,
Editor: Olivia Maddox,