Preparing to fight the past has a long history of failure. Just ask the French at the Maginot Line how well WWI strategy applied to WWII. Still we study history so we can learn from our past mistakes, and making the same mistake over and over again is truly asinine. Still what I propose will only help to avoid the mistakes of the past, not provide a cure for all future troubles and is more than likely to result in other horrible unintended consequences.
How do you prevent financial excess when the human condition naturally causes self reinforcing trends of greed and fear? Automatic stabilizers.
For monetary policy this means the Fed takes the punch bowl away when the party gets going, and turns on the lights and sends everyone home when the party is really rocking. And the next morning when the hangover hits they take you out for Bloody Marys to start your day. I would suggest that the Fed move away from targeting inflation and GDP and focus only on purchasing power. Purchasing power should be based on income and asset growth (savings, and assets including the value of housing) adjusted for inflation of course. While I will leave the exact calculation to those econometrically minded folks I will point out that such a policy means the Fed would not just fight inflation in goods and services but also asset price inflation (i.e. they would raise rates if home prices or stock prices went up too fast). That would obviously be very unpopular.
Below is a chart with the Fed Funds rate in orange and a simple version of purchasing power in white. You will note that if the Fed was focusing on keeping purchasing power growth stable interest rates should have been higher and should have been raised much more in 2001-2003 and cut in Dec 2006. Humm that might have helped.
Monetary policy shouldn’t bear the full burden though. Fiscal policy should also have built in automatic stabilizers. That means when GDP grows above a certain rate government spending should be cut and or taxes raised and visa versa when GDP declines.
One reason for our current mess is that in the past the Fed and the US government have been quick to cut interest rates and taxes when growth and asset prices fall but are slow or unwilling to raise rates and taxes when asset prices rise and GDP growth increases significantly.
Building in serious automatic stabilizers will often mean lower growth, but it will also mean less risk of a deep recession or depression. Slow and steady may win the game, but my bipolar friends tell me they hate taking their meds because they really like the manic times and don’t want to give them up. Of course during the down times they just might jump (course right now joe six pack might just push you).
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