A Bubble in the Bond Market?

Jeremy Siegel and Jeremy Schwartz claim there is a U.S. bond bubble:

Ten years ago we experienced the biggest bubble in U.S. stock market history.... A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites.... We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.... 

While they may be right that bond prices have gone up because of economic pessimism and the associated low interest rates, there is good reason for the pessimism.  It's called a recession, not just any recession but a balance sheet recession. The balance sheets of households in particular have deteriorated so much they are back to where they were about 20 years ago.  It will probably take years to heal household balance sheets.  If so, there is little reason  to believe there is going to be a robust economic recovery anytime soon that will push up interest rates and cause bond prices to crash.  The importance of weak household balance sheets cannot be overstated.  It is the main reason why the federal government balance sheet is currently growing (i.e. the contraction of household balance sheets is being offset by the expansion of the government balance sheet) and therefore is, in part, indirectly responsible for all the concerns about exploding fiscal deficits.  Siegel and Schwartz try to dismiss this concern by saying the problem is overstated but I don't buy it.  Neither do  the economists in the Survey of Professional Forecasters. They see a weak recovery at best at least through 2011.  Even if one accepts Siegel and Schwartz's view that there is excessive pessimism in the market it is still hard to talk about bubbles in the bond market like on does with the stock market as noted by Brad DeLong.   

In short, there is economic weakness a far as the eye can see and this suggests interest rates will probably be low for an extended period of time.  Therefore, even if we do have a bond bubble it is not going away anytime soon.  As Colin Barr says, for now we may be stuck with an unpoppable bond bubble.

Update: Felix Salmon and Karl Smith make similar points.
Update II: Barry Ritholtz doesn't quite call it a bubble, but says it has the markings of something close to a bubble.

Ending the Bubble-Bust-Bailout Cycle

Writing in the New Republic, Simon Johnson and Peter Boone express grave concern that we have made it through this economic crisis only to be setting ourselves up for another one:

[T]he Fed may well have mitigated our current crisis by sowing the seeds for the next one... Our banks have gotten into the habit of needing to be rescued through repeated bailouts. During this crisis, Bernanke--while saving the financial system in the short term--has done nothing to break this long-term pattern; worse, he exacerbated it. As a result, unless real reform happens soon, we face the prospect of another bubble-bust-bailout cycle that will be even more dangerous than the one we’ve just been through.

Johonson and Boone argue that the next bubble-bust-bailout is just part of a pattern that the Fed has inadvertently played into since the 1970s:

Since the 1970s, successive financial crises have required ever more dramatic reactions from the Fed. Every time there is a potential financial meltdown, the Federal Open Market Committee quickly cuts short-term interest rates. These cuts have become larger and larger over time, now essentially taking interest rates to zero. Each round of interest-rate cuts has made sense when a given crisis breaks. But these cuts--which effectively function as bailouts for banks that have gotten into trouble--often helped bring about the next financial crisis. And the crises are getting larger, not smaller, over time.

They go on to document how every Fed chairman since the late 1970s, including the saintly Paul Volker, has been a contributor to this cycle. They also argue that the currently proposed reform of the financial system will not end this cycle:

In June 2009, Treasury Secretary Timothy Geithner unveiled the administration’s plans for reforming our financial sector and preventing a major crisis from happening again. The cornerstone of the proposal is to (slightly) reduce the number of agencies carrying out regulation, and to give new powers to the Fed.

Unfortunately, these changes are unlikely to work. They do not alter the enormous incentive our banks have to take excessive risks. They don’t address the fact that strong financial groups can lobby our lawmakers and beat down regulators until they are largely ineffective. And they don’t affect our propagation mechanism: The printing presses at the Fed remain open and available for when the next crash comes, and that makes creditors confident that they can lend without risk to our heavily leveraged financial sector. As long as this combination remains in place, today’s financial executives fully understand that the party goes on.

Their solution to ending this cycle is to sharply raise capital requirements at banks, make managers and boards of directors at financial institutions personally liable to some extent for their companies, regulate the revolving door between industry and government for financial regulators, and make the Fed more accountable for systemic financial risk.

While their solution list has merit, let me suggest a simple two-step reform package that I believe would end bubble-bust-cycle: (1) initiate a nominal income targeting rule for monetary policy and (2) adopt macroprudential policies. A nominal income targeting rule would helpful for several reasons. First, it would allow the Fed to see beyond the false comfort of maintaining low inflation. The Fed in in 2003-2005 allowed short-term interest rates to remain inordinately low and economic imbalances to grow because, among other things, inflation was reigned in. Had the Fed been looking at nominal income or spending growth, however, during this time it would been more concerned. (A key problem with an inflation focus for monetary policy is that it only works well with demand shocks. Nominal income targeting , on the other hand, handles both demand and supply shocks. See here for more.) Second, a nominal income targeting rule if strictly followed would help the Fed move away from making bailouts. By stabilizing nominal spending or nominal income, the Fed would minimize the booms, the bust, and thus the need for bailouts. While I believe a nominal income targeting rule would take us a long way in improving both macroeconomic and financial stability, it may not be enough given the political realities outlined above. Consequently, macroprudential regulations such as a countercyclical element to capital requirements would provide a nice complement. Together, these two polices should bring us closer to ending the financial bubble-bust-bailout cycle.

Monetary Policy and Asset Bubbles

Gerald P. O'Driscoll Jr. has a new paper titled Asset Bubbles and Their Consequences. The paper discusses how many of the recent asset boom-bust cycles had their origins in an overly accommodative monetary policy. From the summary:

[M]onetary policy has become a source of moral hazard. In acting to counter the economic effects of declining asset prices, the Federal Reserve has come to be viewed as underwriting risky investments. Policy pronouncements by senior Fed officials have reinforced that perception. These actions and pronouncements are mutually reinforcing and destructive to the operation of financial markets. The current financial crisis began in the subprime housing market and then spread throughout credit markets. The new Fed policy fueled the housing boom. Refusing to accept responsibility for the housing bubble, the Fed’s recent actions will likely fuel a new asset bubble.

O'Driscoll makes a point in the paper to which I am partial:

In a vibrant market economy with technological innovation and ever new profit opportunities, the monetary policy that maintains price stability in consumer goods (or zero price inflation) requires substantial monetary stimulus. That stimulus will have a number of real consequences, including asset bubbles. These asset bubbles have real costs and involve misallocations of capital. For example, by the peak of the tech and telecom boom in March 2000, too much capital had been invested in high-tech companies and too little in “old economy firms.” Too much fiber optic cable and too few miles of railroad track were laid.

By 2002, the Fed was worried about the possibility of price deflation. The experiences of Japan in the 1990s and the Great Depression were clearly weighing on the minds of policymakers. A tilt to stimulus was understandable at the time. A continued bias against deflation will, however, produce a continued bias upward in price inflation. With the bursting of each asset bubble and the fear of deflationary pressure, Fed policy must ease. The inflation rate begins at the positive number. The Greenspan doctrine prescribes a simulative overkill that begins the cycle anew.

This story makes sense to me. As I have argued elsewhere, the Fed's deflation concerns were off the mark by 2003. Deflationary pressures by that time were the result of rapid productivity growth, not weak aggregate demand. The Fed's easing then, pushed the real interest rate below the natural interest rate and set off a Wicksellian disequilibrium. The housing boom was one manifestation of this development.

Read the rest of the O'Driscoll paper.

What the Fed is Avoiding in its Bubble Discussions

More discussion is emerging across the blogosphere (here, here, here, and here) on how monetary authorities can better manage asset bubbles. This discussion has emerged in response to the Federal Reserve's own growing interest in this issue. The Financial Times first reported this development a few days ago and now the Wall Street Journal in both its print edition and in its RTE blog (here, here, and here) have been providing additional coverage. What we have learned so far about the Fed's thinking is that while it is open to using prudential regulation and monetary policy in stemming future asset bubbles, it is less enthused about the latter option. (This bias toward prudential regulation was especially clear in the speech last night of Fed governor Frederick Mishkin.)

Interestingly, what little discussion has been given to the monetary policy option has been framed around how monetary policy should respond given there is an asset bubble (e.g. prick it by increasing interest rate). What is not being discussed by Fed officials--at least I am not aware of any such discussions--is whether loose monetary policy itself helped create the U.S. asset bubbles of past decade. Ignoring this facet of the debate means ignoring discussions on how to improve the conduct of monetary policy so that it minimizes the emergence of asset bubbles in the first place. The RTE blog reports in a similar vein:

But amidst all this debate, the Fed has not dwelled much on the role its own monetary and regulatory policies may have played in fueling the housing bubble. James Bianco of Bianco Research complains that the Fed has looked everywhere for a solution but at itself. “It seems that the Federal Reserve thinks bubbles are caused be everyone and everything except, say, a 1% fed funds rate or special liquidity facilities,” he writes in a commentary today. If Mr. Mishkin wants to use the Fed’s powers more proactively to arrest bubbles, he “should stop voting for irresponsible expansions of Federal Reserve credit that create and promote bubbles.

While I differ with James Bianco regarding the Fed's clever use of its balance sheet to stem the current credit crisis, I do agree with the spirit of his argument--the Fed's loose monetary policies in the past was the fuel that started the asset bubbles. At a minimum it would be worthwhile to consider the asset price implications of its past policies and whether alternative approaches could do better. I have already expressed my view on this matter: the Fed would do a better job minimizing asset boom-bust cycles by adopting a nominal income targeting rule.

Let me close by noting that the Fed's is late in joining this debate. The Europeans have been thinking about these issues far longer. In particular, I would point any interested reader (or Fed official) to the works of Claudio Borio, Andrew Filardo, William White, and others at the BIS. These observers take seriously improving both prudential regulation and monetary policy. Here is a posting of mine that provides some links to their works.

Paul Krugman Needs a Dose of the Julian Simon Cheer Up Elixir

Paul Krugman is concerned about the rising prices of commodities and their long-term economic implications:

[T]he global surge in commodity prices is reviving a question we haven’t heard much since the 1970s: Will limited supplies of natural resources pose an obstacle to future world economic growth?

How you answer this question depends largely on what you believe is driving the rise in resource prices. Broadly speaking, there are three competing views.

The first is that it’s mainly speculation — that investors, looking for high returns at a time of low interest rates, have piled into commodity futures, driving up prices. On this view, someday soon the bubble will burst and high resource prices will go the way of Pets.com.

The second view is that soaring resource prices do, in fact, have a basis in fundamentals — especially rapidly growing demand from newly meat-eating, car-driving Chinese — but that given time we’ll drill more wells, plant more acres, and increased supply will push prices right back down again.

The third view is that the era of cheap resources is over for good — that we’re running out of oil, running out of land to expand food production and generally running out of planet to exploit.

I find myself somewhere between the second and third views.

[...]

[R]ich countries will face steady pressure on their economies from rising resource prices, making it harder to raise their standard of living. And some poor countries will find themselves living dangerously close to the edge — or over it. Don’t look now, but the good times may have just stopped rolling.

Krugman needs to cheer up. Yes, soaring commodity prices are causing economic and political strains across the globe, but increased scarcity and the resulting higher prices are the mother of innovation. Higher prices in a market system send the signal--dare I say the profit motive--that there is a need to find new, more efficient ways to produce those goods and services that are sorely needed. This process can take time and there may be some market failure along the way, but by and large the advances humanity has made over the last few hundred years are a testament to how this process works.

Look at oil. Prior to the 1850s, sperm whale oil was the preferred fuel for lighting. However, sperm whales were and are a limited natural resource. Consequently, as sperm whale oil consumption increased, the sperm whale population decreased and the price of sperm whale oil shot up. Commodity prices were soaring and concerns were being aired about what we would call 'peak' sperm whale oil production. It was no coincidence then that around the 1850s people like Edwin Drake were looking for alternative energy sources. The price signal was screaming to entrepreneurs to "innovate...find new energy sources...high financial rewards to those who do" And so the petroleum industry took off and sperm whales were spared. I suspect the same is happening today to fossil fuels. There is increased petroleum scarcity given the growth of China et al. and the limited oil reserves in the world. As a consequence, the resulting high prices over time should lead to (1) increased efficiency with existing oil reserves (e.g. better mpg technology) or (2) alternative energy sources altogether. And this is just what the world needs in terms of pollution control and oil-influenced politics.

The key point is that this increased commodity scarcity should lead to new innovations that will, if anything, lead to higher standards of living in the future. Of course, all of this is not new. The late Julian Simon wrote about this process in his book "The Ultimate Resource II." Simon's argument is that human creativity when faced with increased scarcity is the ultimate resource. Don Boudreau has a nice discussion here on some of Simon's insights.

So, yes, Paul Krugman there are reasons to be hopeful. I would recommend a dose a day of the Julian Simon Cheer Up Elixir until your anxiety symptoms disappear.

P.S.
Of course this entire discussion is premised on the notion that the run up in prices is due to fundamentals. There, of course, is an alternative explanation for the surge in prices: loose monetary policy and speculation. See Jim Hamilton for more.

UpdateI : Michael Mandel tells us to "Throw Malthus Off the Bus!"
Update II: Tyler Cowen gives a rebuttal to Krugman's rebuttal.

Commodity Bubble?

I previously asked whether the next bubble will be in commodities. Yves Smith has chimed in on this discussion over at Naked Capitalism in light of a recent article in the Telegraph titled "Fears of a Commodity Crash Grow." One excerpt from Smith:

[The author of the article,] Evans-Prichard [,] is not saying that commodities will go into a long-term decline. However, given a 20% runup in many indices in a mere two months after a 30+% increase last year, some observers deem the market to be overbought and due for a correction. Evans-Pritchard points out that if you believe that the US and Europe are going to enter a recession (insiders believe that European financial institutions will soon see the kind of stress their US peers have suffered), Chinese demand isn't strong enough to justify continued robust prices (ex agriculture).

As parting food for thought, I have posted below two graphs of the commodity-tracking CRB Index.

The Housing Boom-Bust Cycle as a Roller Coaster Ride

Here is a great video clip that portrays real U.S. housing prices as roller coaster ride. Unfortunately, the video clip only goes through the beginning of 2007 so the 'bust' part of the housing 'boom-bust' cycle is missing. Nonetheless, the video clip helps put perspective on the magnitude of the U.S. housing boom... fasten your seat belt.

Asset Bubbles... and Monetary Policy

There was an interesting article this past week from Daniel Gros who reminded us that the boom-bust cycle in the U.S. housing market is not unique. Rather, there are also "House Price Bubbles Made in Europe." Here is a figure from his paper that compares real housing prices in the Euro area and the U.S. through 2006:

It is interesting how real housing prices in the Euro area follow a similar pattern to the U.S. real housing, albeit with a lag. As JMK has noted in the comment sections of this blog, this common movement in real housing prices means my often-expressed past monetary profligacy view (here, here, here, and here) cannot be the whole story. Financial innovation, low financial literacy, predatory lending, and excess saving from other parts of the world are meaningful contributors too. Nonetheless, the macroeconomist in me has a hard time believing these factors as being completely independent of--or as consequential as--loose monetary policy in advanced economies coupled with boom psychology.

To illustrate my point here is a figure (click here for a larger file) from one of my working papers:

The first graph in the figure plots the year-on-year growth rate of quarterly world real GDP against a weighted average G-5 short-term real interest rate. The quarterly world real GDP series is constructed by taking the quarterly real GDP series for the OECD area and using it with the Denton method to interpolate the IMF’s annual real world GDP series. This figure reveals that just as the global economy began to experience the rapid growth in the early 2000s, the G-5 short-term real interest rate turned negative as monetary authorities in these countries eased monetary policy. This positive G-5 interest rate gap—the difference between the world real GDP growth rate and the G-5 short term real interest—narrowed as the short-term real interest picked up in 2005, but it still fell notably short of the world real GDP growth rate by the end of 2006. Two measures of global liquidity corroborate the easing seen by the positive G-5 interest rate gap. The first measure is a ratio comprised of the widely used ‘total global liquidity’ metric, which is the sum of the U.S. monetary base and total international foreign reserves, to world real GDP. The second measure is a ratio comprised of a G-5 narrow money measure, which is the sum of the G-5’s M1 money supply measures, to world real GDP. Both measures show above trend growth beginning in the early 2000s. The bottom panel of Figure 5 shows some of the consequences of this global liquidity glut: real housing prices soar in the United States and United Kingdom and are systematically related to the positive G-5 interest gap. (I would love to get Daniel Gros' real housing price index for the Euro area and run a scatterplot of it too)

So in the end I am stuck on the view that loose monetary policy (in conjunction with boom psychology) was very important to the housing boom-bust cycle of the past few years.

The Tradeoff between Output Price Stability and Asset Price Stability

One area of interest to me is the distinction between malign and benign deflation. As I have noted before, malign deflation is the result of negative shocks to aggregate demand and is what most observers invoke when discussing deflation. Benign deflation, on the other hand, is less well known and arises from positive shocks to aggregate supply (AS) not accommodated by monetary policy. Now positive AS shocks, such as those coming from rapid productivity growth, generally mean a higher neutral interest rate and faster trend growth for the economy. If the monetary authority, however, wishes to stabilize the price level in the face of such positive aggregate supply shocks it will have to lower its policy rate below the neutral interest rate. In turn, this response by monetary policy lowers the cost of capital relative to the return on capital. More leverage now makes sense and sets the stage for a potential credit boom. Throw in some "irrational exuberance" to this mix and you have an asset price boom party.

Now had monetary authorities allowed the benign deflation to emerge, the policy rate and the neural rate would be better aligned and there would be no credit boom. Asset prices, in turn, would better track fundamentals.

This story I just told implies that there is a trade off between stabilizing output prices and asset prices when AS is growing. Is there any evidence for this claim? Below are several scatterplots that plot real S&P stock price growth rate against the CPI growth rate for the period 1871 to the present. The data are in monthly frequency and come from Robert Shiller's database. There are several graphs based on different growth rate measures for each variable: a 2-year growth rate, a 3-year growth rate, and a 5-year growth rate. Here is the scatterplot using 2-year growth rates:


Not much going on here, so now take a look at the scatterplot using 3-year growth rates:



The results are getting more interesting as there is almost a Phillips curve-like form emerging amidst the noise. To make better sense of this graph, recall that the output price-asset price trade off is conditional on there being positive economic growth. The above graph, however, includes all data points, including those that occurred during during economic downturns. To clean up this potential noise, I created another graph where I excluded all points where output prices and stock prices are both negative (i.e. eliminate points from quadrant 3). The assumption here is that if both variables are negative there must be economic weakness. After this adjustment, the trade off curve is even more apparent.

Now, take a look at the scatterplot using 5-year growth rates (without any adjustments):

Again, an output price-asset price trade off is suggested by the figure. To whiten some of the noise in the scatterplot, I once again remove points from quadrant 3. Now the scatterplot looks as follows:

These figures all indicate there is a potential trade off between stabilizing output prices and asset prices. While further refinements are needed in these figures, they add perspective to what I have been arguing in my blog: the Fed in its attempt to prevent benign deflationary pressures from materializing over the past few years has been fueling financial imbalances, particularly asset prices. In short, the Fed has been exploiting the trade offs implicit in the figures above. Now, I need to coin a clever name for the trade off curves above. Any suggestions?

Update

The figures above are illuminating, but I do not want to oversell them. While I am still convinced the Fed was trading asset price stability for output price stability over the past few years, I am eager to find more solid evidence than that presented above.

Below is another figure I created using the aggregate asset price indices from the BIS. The BIS aggregate asset price indices consist of real estate and stocks so they are a broader measure than a stock index alone. In this figure I plot the yoy % change in the real asset prices against the yoy % change in the price level for the years 1971-2005. Like the graphs above, this figure is suggestive too of a trade off between output price stability and asset price stability.

Martin Wolf Drinks the 'Saving Glut' Kool-Aid

Martin Wolf is one of the best columnists in the financial press and I have always looked forward to reading his column in the Financial Times (FT). His columns bring fresh insight and reason to many of the big issues facing the world. So you can understand my utter shock when I opened Wednesday's FT and saw this title hanging over his column: Why the Federal Reserve has to Keep the Party Going.

After coming to from my initial state of shock, I sat down to read what Martin Wolf had to say. I was hoping his title was just some clever way to get readers attention, but alas it was not. Poor Martin Wolf apparently has had one-too-many drinks of the 'saving glut' kool-aid. It is one thing to argue for the 'saving glut' theory as a way to interpret the current global imbalances facing the world, but it is absurd to invoke it as a reason for the Federal Reserve to cut its policy rate to 'keep the party going'. His main point is that given the current global 'saving glut', the Federal Reserve must do its part to ensure that the U.S. economy, the demand engine of the world economy, keeps running. Consequently, to the extent the current financial crisis causes this important engine to sputter, the Federal Reserve should act aggressively.

There are several problems with his view. First, he ignores the 'liquidity glut' view of the current global imbalances that says at least some of the excess saving coming out of the periphery countries of the world has been due to the excessively accommodative monetary policy in United States. The story is that with U.S. monetary policy set on super easy between 2001 and 2005 and putting downward pressure on the dollar, these periphery countries who depend on a export-driven growth strategy for development had to buy massive amounts of foreign reserves to maintain both their peg to the dollar and their external competitiveness. Excess saving emerged as the result of these countries currency interventions--which again, were set off and driven by the loose monetary policy in the United States--that effectively increased the price and reduced the quantity of domestic consumption. Of course, the periphery countries could have chosen not to intervene in currency markets, but given that they did one clear implication is that the excess saving to some extent is a consequence of a policy choice made in Washington D.C. Asking the Federal Reserve to keep 'the party going' then is asking it to perpetuate it share of the global imbalances.

A second, related problem are the implications of his recommendation. As Catherine Mann notes in her response to this column, Martin Wolf essentially is prescribing more U.S. household indebtedness to maintain domestic demand and keep the global economy going. But is that not one of the very reasons we are in this financial quagmire now? Is not an overextended household sector one of the real economic distortions that has to be worked out? As Catherine Mann points out, "[i]t seems to me that continued unsustainable increases in household indebtedness should not be the outcome of Federal Reserve policy, no matter how important consumer spending is to the overall performance of the US economy." Why would we want more more asset bubbles and leverage when these very things put us where we are today.

Martin, it is time to put down the 'saving glut' kool-aid

The Economist Magazine Asks a Troubling Question

The Economist magazine asks a troubling question: does America need a recession? The answer may at first seem an obvious 'No!', but looking back to the example of former Federal Reserve chairman Paul Volker tempers this conclusion. As chariman, Paul Volker in the early 1980s successfully engineered two sharp recessions that are credited with creating the stable macroeconomic environment important to the subsequent 20+ years of U.S. prosperity. Back during Volker's time the recessions were used to lick inflation, today the argument for a recession rests on removing the real economic distortions (e.g. housing glut) created during the 2001-2005 monetary binge.

From the Economist:

Does America need a recession?

"...But should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows?

Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the downturn was the benign result of the American economy's increased flexibility, better inventory control and the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its history. By slashing interest rates... the Fed encouraged a house-price boom which offset equity losses and allowed households to take out bigger mortgages to prop up their spending. And by sheer luck, tax cuts, planned when the economy was still strong, inflated demand at exactly the right time.

Many hope that the Fed will now repeat the trick. Slashing interest rates would help to prop up house prices and encourage households to keep borrowing and spending. But after such a long binge, might the economy not benefit from a cold shower? Contrary to popular wisdom, it is not a central bank's job to prevent recession at any cost. Its task is to keep inflation down (helping smooth out the economic cycle), to protect the financial system, and to prevent a recession turning into a deep slump.

The economic and social costs of recession are painful... [b]ut there are also some purported benefits... [o]nly by allowing the “winds of creative destruction” to blow freely [can] capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.

Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.

Update

Mark Thoma comments on this piece and receives a lot of interesting comments