Cutting The Wheat From The Chaff...With A Flamethrower

In baseball the eternal "which is better" war is pinch hitters versus pitchers that hit, in cooking it's butter versus margarine, and in economics the battle is the Austrian school versus the Keynesians.  They must fight, it is the way of all things, grasshopper.

This week the Austrians are trying to make the case that Keynesian economics has failed, and it's time to try the Austrian approach.  We're past the point of saving businesses and homeowners, the Austrians say, and for the good of the economy we need to shed those on the margins only by the grace of the taxpayers and free up those economic resources to be used by those who are making it.  With the annual Fed conference at Jackson Hole, Wyoming coming up on Thursday, the economic theory ammunition is already flying and the Austrians are making their move.

Raghuram Rajan accurately warned central bankers in 2005 of a potential financial crisis if banks lost confidence in each other. Now the International Monetary Fund’s former chief economist says the Federal Reserve should consider raising rates, even as almost 10 percent of the U.S. workforce remains unemployed.

Interest rates near zero risk fanning asset bubbles or propping up inefficient companies, say Rajan and William White, former head of the Bank for International Settlements’ monetary and economic department. After Europe’s debt crisis recedes, Fed Chairman Ben S. Bernanke should start increasing his benchmark rate by as much as 2 percentage points so it’s no longer negative in real terms, Rajan says.

“Low rates are not a free lunch, but people are acting as though they are,” said White, 67, who retired in 2008 from the Basel, Switzerland-based BIS and now chairs the Economic Development and Review Committee at the Paris-based Organization for Economic Cooperation and Development. “There will be pressure on central banks to follow an expansionary monetary policy, and I worry that one can see the benefits, but what people inadequately appreciate are the downsides.” 

Raise interest rates two full percentage points or more, time to jettison the weak and the feeble and let the strong survive.  Never mind that this would almost certainly drive unemployment into the stratosphere and make things infinitely worse for 95% of the country.  Paul Krugman, arguably the most visible Keynesian today, seems to think Rajan and White are just literally making stuff up, but I think Krugman is being naive here.  These guys know exactly what jacking up interest rates 200 BP would do to the economy.

It's separating the wheat from the chaff with a flamethrower, it's curing a staph infection with a chainsaw.  They want to burn and cut away those who are unable to function without these low rates and force everyone into a deep thrift mode, bringing our economy to a dead halt.

Clear the playing board and start over.  Reboot the machine.  Flush the system.  They know what this would entail, and they figure it's going to happen anyway, so you might as well make it a controlled burn.  The problem of course is "it could happen, so let's make sure it happens" isn't a very good way to go when the "happening" in question is a massive economic depression.

Odds a very good it will happen anyway given where housing is.  But raising rates that much would make it a certainty, and nobody should be willing to do that.