It is important to realize that even now Fed officials are not quite sure how they pulled this rescue off. At… — Paul R. Krugman
It is important to realize that even now Fed officials are not quite sure how they pulled this rescue off. At the height of the crisis it seemed entirely possible that cutting interest rates would be entirely ineffectual—after all, if nobody can borrow, what difference does it make what the price would be if they could? And if everyone had believed that the world was coming to an end, their panic might—as in so many other countries—have ended up being a self-fulfilling prophecy. In retrospect Greenspan seemed to have been like a general who rides out in front of his demoralized army waves his sword and shouts encouragement, and somehow turns the tide of battle: well done, but not something you would want to count on working next time.
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Indeed, there has long been a strand of thought that says that moderate inflation may be necessary if monetary policy is to be able to fight recessions. Still, advocates of inflation have had to contend with a deep-seated sense that stable prices are always desirable, that to promote inflation is to create perverse and dangerous incentives. This belief in the importance of price stability is not based on standard economic models—on the contrary, the usual textbook theory, when applied to Japan’s unusual circumstances, points directly to inflation as the natural solution. But conventional economic theory and conventional economic wisdom are not always the same thing—a conflict that would become increasingly apparent as one country after another found itself having to make hard choices in the face of financial crisis.
As I’ve just noted, Greenspan warned about irrational exuberance, but he didn’t do anything about it. And in fact, the Fed chairman holds what I believe is a unique record among central bankers: he presided over not one but two enormous asset bubbles, first in stocks, then in housing.
But this warning was ignored, and there was no move to extend regulation. On the contrary, the spirit of the times—and the ideology of the George W. Bush administration—was deeply antiregulation. This attitude was symbolized by a photo-op held in 2003, in which representatives of the various agencies that play roles in bank oversight used pruning shears and a chainsaw to cut up stacks of regulations. More concretely, the Bush administration used federal power, including obscure powers of the Office of the Comptroller of the Currency, to block state-level efforts to impose some oversight on subprime lending.
