Lunch at the Labs

Putting out financial fires

In his New York Times Magazine article How Did Economists Get It So Wrong? Paul Krugman (like most everyone else) misses a key point. As is pointed out in Fire in the National Forest System, the size of forest fires has been increasing rapidly, at least partly due to the "Smoky Bear" campaign to quickly put out small fires and the lack of prescribed burning. But fewer small fires leads to disastrous large conflagrations.

It seems something similar has happened with our economy. The Federal Reserve has been very good at putting out small fires in the economy; for example, the 1987 stock crash, the 1997 Asia crisis, LTCM in 1998, and the dot-com bubble of 2001. As Krugman puts it:

(1985-2007) were the years of the Great Moderation - an extended period during which inflation was subdued and recessions were relatively mild.

But this resulted in a large increase in financial "underbrush" in the form of lower interest rates, lack of regulation, acceptance of risky behavior, etc. and finally an out of control financial fire.