NRI Fellow John Chapman

With regard to John Snow's Dec. 27 op-ed "Medicine for an Ailing Economy": While his defense of the Bush tax cuts and calls for banking industry recapitalization and restructuring are correct, his other ideas are off the mark. Mr. Snow incorrectly opines that a world-wide glut of "excess savings" caused housing assets to be "bid up" due to low interest rates, which also induced the creation of "opaque asset-backed" securities that were too risky and hence underpriced. The subsequent correction in housing values and repricing of risk has harmed credit markets, however, and thus calls for further loosening of monetary policy, "despite the most recent inflation reports," as well as more stringent regulation of the financial services sector.

If in fact a world-wide glut in savings had occurred, real interest rates everywhere would be lowered, and a boom in time-intensive production of capital goods--including housing--would be fully sustainable by those real savings. Further, there would be no systematic mal-investment in any one capital goods sector such as housing, because production spreads across all sectors of the economy, and in general lowers real commodity prices.

Instead, what happened is the Greenspan Fed held U.S. interest rates too low for way too long earlier this decade. Inflationary increases in credit, channeled through the banking system into credit markets, fed the housing boom. But as this boom was not backed by an increase in real savings, it was by definition unsustainable.

Further, because the U.S. dollar is the world's de facto reserve currency, the Fed can "export" inflation for a time. But this too is unsustainable, as over time the dollar must fall, and U.S. inflation and real interest rates rise, to adjust to too-expansionary a monetary policy. More monetary easing is exactly what should not happen now. What we do need is less federal intervention, which breeds moral hazard in the U.S. financial system, and in turn the asset repricing, recapitalization and restructuring Mr. Snow applauds will quickly stabilize financial markets. Additionally, broader tax cuts and lower federal spending will help prevent a recession.

John L. Chapman is an NRI fellow at AEI.