Paul Samuelson on the New Financial Instruments and Monetary Policy

Paul Samuelson has a must read in the International Herald Tribune:

Today, Federal Reserve Chairman Ben Bernanke admits that nobody, including him, is able to guess how near to bankruptcy the biggest banks in New York, London, Frankfort and Tokyo might be as a result of the real estate crisis. As one of the economists who helped create today's newfangled securities, I must plead guilty: These new mechanisms both mask transparency and tempt to rash over-leveraging. Why should non-economist readers care about these technicalities?

Dr. Samuelson’s explanation of the implications for monetary policy after the jump.

Because the policy tools that served so well for Alan Greenspan's Federal Reserve and for the Bank of England now have to be changed. It used to be enough for a central bank to "lean against the wind." That means lower interest rates when unemployment is too high and when deflation threatens. And when business growth is too brisk, central banks are supposed to raise their interest rates to dampen growth and to forestall price-level inflation that threatens to exceed 2 percent per year. Today, central bankers and U.S. Treasury cabinet officers cannot know whether current interest rates are too high or too low. This is surprising, but true. The safest bond interest rates are indeed low. But financial panic engendered by the burst bubble of unsound U.S. and foreign mortgage lending means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.

I can recall my macroeconomic professors complaining about the shorthand of “the interest rate”, but this seemed like a quibble in the real world of policy making until we hit the Bush41 recession. Of course, President George H. W. Bush was trying to end the S&L crisis and raise tax rates at the same time, which likely made the FED’s job more difficult during his Administration. I don’t pity the task the FED is tasked with now either. Dr. Samuelson rightfully advocates a little more regulation of lending practices. But couldn’t more regulation of financial markets have a similar impact to the S&L reforms during Bush41’s era? Dr. Samuelson has a little more advice for our policymakers:

Watch developments closely. If America's Christmas retail sales fail badly - as they could when high energy prices and high mortgage costs pinch consumers' pocket books - then be prepared to accelerate credit infusions by central banks on the three main continents ... What the world does not need now is tolerance for any persistent weakness in global Main Street growth. It is better when physicians worry too much about a patient's health than when they worry too little.

I hope Chairman Ben will follow Dr. Samuelson’s advice.