Saturday, March 8, 2008

Paul Krugman on rate cuts

Paul Krugman makes a case for lower rates in the US despite the growing fears that it will generate inflation and fuel moral hazard concerns, with a parable.

He writes,"There’s an old joke that Jacob Frenkel, formerly of Chicago and then the Bank of Israel, used to tell to illustrate the fallacy of thinking that you always have to do the opposite of what caused the initial problem. A driver runs over a pedestrian; he looks back, realizes what he’s done. “I’m so sorry,” he says. “Let me fix the damage.” So he backs up, running over the pedestrian a second time.

What we have now is a spending slump. It’s the consequence of easy credit that led to reckless spending in the past — but the problem now is how to sustain spending; trying to encourage austerity at this point will just make things even worse. Keep cutting, Ben!"

But the rate cutting prescription can succeed only if it goes hand in hand with tighter regulation of the financial market instruments and participants, especially of banks and institutions like hedge funds and private equity firms, and controls on cross-border capital flows. It should also simultaneously treat the indigestion and paralysis caused by the excesses of irresponsible and greedy borrowers and lenders.

Merely cutting interest rates while ignoring the fundamental problem at hand, is similar to the driver driving away without stopping, at the same speed, leaving the poor victim to succumb to his injuries!

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