Federal Reserve governor Ben Bernanke does not lack advice. But when Martin Feldstein, an eminent economist who was a rival to Bernanke as Alan Greenspan’s successor at the Fed, calls for a 1% cut in the Fed Funds rate, the world listens. Feldstein’s advice shows he might indeed have proven a faithful successor to Greenspan. Bernanke can do better than that.
It is not that Feldstein’s analysis of the damage falling house prices could do to growth is wrong. The main impact of falling house prices is through what economists call “net household wealth”. When assets go up in price, owners feel richer and spend more. When asset prices fall, the reverse happens. And so, if the US house prices fall further, which seems inevitable, spending and growth will suffer.
But the house price bubble had to end some time, and so far, its bursting hasn’t done too much damage. Second quarter annualized GDP growth was 4.0% and would have been 4.6% without a fall in house building. The latest economic data, the ISM index of manufacturing activity for August, was not much down on July and well above recessionary levels.
The ISM reading on prices suggested that inflationary pressure is continuing. Feldstein, however, is suggesting that inflation should be forgotten and risks to growth be tackled early, to prevent a possible downturn. That, after all, is what maestro Greenspan always did, most notably in the autumn of 1998 when, with 75 basis points in cuts, he transformed a credit crunch similar to today’s into the euphoric bubble of 1999—which was followed by the long-lived deflationary bust of 2000.
That experience shows that preemptive strikes are not always wise. The huge cut in rates that Feldstein suggests could be disastrous: inflating the markets once again—and creating still greater danger in the future.
If Bernanke spares his fire now, he can both avoid an ill-deserved bail-out of speculators and leave himself with ammunition for later, if the US economy does indeed slow markedly. He would curb dangerous excess, rather than encouraging it—as Greenspan did, and Feldstein, it seems, might have done.