Economics for knuckleheads

Larry, Curly, Moe and the Economy

By Ben Stein
New York Times
January 13, 2008

NOW for a few short notes on the economy — and you can digest them along with your FiberCon and your English muffins.

Clearly, the economy is slowing. The immense drop in home construction, the slowdown in lending, the falloff in retail sales, the general mood of the nation — fanned by endless fear-mongering in the news media — are taking their toll. There has been a noticeable gain in joblessness, although employment is still very strong by historical standards. Foreclosures are way up, though they still form a tiny percentage of all homes with mortgages.

Banks have sometimes been reluctant to lend, and this is scaring markets plenty. The stock market is down sharply from six months ago. It is still at a high price-to-earnings multiple by historical measures, but it has fallen.

We have a situation that calls for highly stimulative measures from the Federal Reserve. These will involve lowering interest rates charged to the banks for loans, and creating money to improve liquidity. Help appears to be on the way, but more is needed. Please permit me to say why we are still behind the curve.

The problem — as the Fed perceived it until last week and maybe even now — is that there are also signs of inflation. There are especially strong signs of inflation in oil prices.

Until this past week, the Fed has been reluctant to ease credit as much as some people would like, for fear of stoking too much demand and stimulating inflation. It’s pretty much agreed by now that inflation comes from the demand side. Thus, as a matter of definition, because much of the increase in prices comes from oil price increases, one can safely assume that the Fed believes there is excess demand for oil.

A month ago, the Fed lowered rates by only a quarter of a percentage point instead of making the half-point cut that many were expecting. The Fed appears to have made a big mistake about oil and aggregate demand at the last rate-cut session — for several reasons.

First, the big drivers of added demand for oil are not really subject to Fed control. China, India and other developing nations are responsible for the bulk of increased demand. The Fed does not have the power to lower demand for oil in the developing nations, except in a very indirect way.

In other words, punishing the United States economy because oil prices are high is attacking the wrong culprit. It’s sort of like a Three Stooges movie in which the wrong person keeps getting hit on the head.

Second, oil demand is largely based on weather at this time of year. The Fed has zero control over the weather, and most people will heat their homes even if there is a recession. Thus, that aspect of inflationary pressure will continue as it stays cold and will abate as the weather warms.

Third, food prices are also a source of inflation. These prices are rising largely because of a highly debatable government policy that mandates production of a huge amount of ethanol for use in motor fuel. So much corn is taken up by this that less is left for feed crops. This pushes up the price of feed and makes consumers pay more for groceries.

It’s extremely questionable whether this is good policy. Ethanol, at this point, is believed by many to be an energy loser, because it can take more energy to make a gallon of ethanol from corn than ethanol produces. It is also believed to be more inefficient at powering vehicles than gasoline. Now, ethanol fans angrily rebut this, and technology may well end up making ethanol more efficient. But for now, why take land away from making food to make a fuel that basically adds little to energy conservation?

Whatever the benefits or the problems of ethanol, the fact that it is taking up so much crop land is a big driver of inflation, and the Fed cannot do much about the effects of that.

In short, the Fed was not stimulating the economy enough because of fears of oil price-driven inflation. But it should have been worrying more about credit and growth. That is why the comments last week by Ben S. Bernanke, the Federal Reserve chairman, about leaving the door open to rate cuts were so reassuring. But he did not leave the door open wide enough.

ALAS, the Fed is still behind the curve. There is a real solvency fear out there right now — a fear to lend at all, even at apparently advantageous rates. The Fed must act decisively to calm these fears by reassuring lenders.

This might even take the form of legislation allowing the Fed to buy stock in large banks on a temporary basis. The banks are already largely socialized through federal deposit insurance. To add the prop of government capital infusions is not such a big step.

Let the Fed concentrate on stimulation. No matter what, we’ll get through it all, but why make it more painful than it needs to be?

Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.