The U.S. cannot afford to have another lost decade. Or to see the dreams of another generation of Americans who had been told to take responsibility for their financial health by investing in the stock market dashed by failed monetary and fiscal polices.
Today, the most urgent task facing President‐elect Barack Obama is stabilizing financial markets by instituting policies that foster economic growth and prevent the type of boom and bust cycle that has just wiped out a decade’s worth of wealth accumulation.
Mr. Obama’s task is made all the more difficult because there has been a perfect storm of bad policies and practices. Laudable goals, such as fostering more homeownership, went terribly awry. Financial services regulation has failed at its most basic task, protecting the soundness of the system. And a dysfunctional compensation system has given corporate managers incentives to take excessive risks with investors’ money.
None of the policies and practices that are now widely criticized suddenly appeared in the past decade. But they were kindling for a financial firestorm that needed only an accelerant and a spark. Both were provided by a policy of easy money that came in response to the bursting of the dot‐com bubble in 2000-01, the ensuing recession, and the Sept. 11 attacks.
At first Fed easing was in order. The central bank needed to counter the “irrational exuberance” of the dot‐com bubble. And by May of 2000 the Fed had done that by raising the fed‐funds target to 6.5%. That needed to come down when the bubble burst. Aggressive cutting brought it to 2% in November 2001.
The problem is the rate remained at 2% or less for three years (for a year it was at 1%). During most of this period, the real (inflation‐adjusted) fed‐funds rate was negative. People were being paid to borrow and they responded by often borrowing irresponsibly.