Is the US government really doing the right thing?

The US government has been praised for the way it has reacted to the current financial crisis. The US government has acted quickly on both monetary (reducing interest rates) and fiscal (providing stimulus packages and tax rebates) fronts. However the basic question remains, is the US government really doing the right thing?

Consider the analogy of a person who falls ill. The doctor can give the patient a medicine which takes a week to take effect and will cure the person completely. Thus the patient will slowly get better in a week. Alternatively, the doctor can give the patient steroids, which will make him feel better within a day, however it will only suppress the disease. The person, in this case, feels better in a day, goes to work the next day and is generally happy. Till after a couple of months - the disease comes back with renewed force...

Let us look back at what happened in the US in 2000-2001. Events like the dot com burst and 9/11 raised the possibility of a US economic recession. The response of the US Federal Reserve (or the Fed) was to reduced interest rates drastically (from 6.5% to 1%), in its bid to spur the economy. This acted like a steroid and sure enough the economy picked up.

However, the question remained – did the Fed cut interest rates too low? Should it have let the economy go through a slow recovery rather than try to artificially stimulate it? To deal with the dot com bubble, had the Fed sown seeds for a bigger mortgage bubble?

As with the patient example, the economy has now tanked even more badly after 5 years. In order to prevent a minor downturn then, the Fed has inadvertently led the country to a major downturn.

An economic downturn is not necessarily bad. It is one half of the overall economic cycle of boom and burst. A downturn in the US would lead to the demise of old, uncompetitive companies so that new, competitive companies can take hold. By bailing out these companies (for example the big 3 in automobiles) the US government is trying to keep alive uncompetitive, value destroying companies. A downturn also leads to stability in prices and acts as a balance for the inflation during a boom period. The current downturn is actually helping genuine buyers find homes, after the steep correction in house prices. A downturn also leads to a drop in currency which should help boosts exports and correct the balance of trade crisis – which the US so desperately needs. However if a downturn is not allowed to run its course, it can have nasty consequences.

The Fed response to the current downturn has been the same as 2002 – if anything, much swifter. It has rapidly reduced interest rated from 5.25% to almost zero. It has also used big fiscal measures like the income tax rebate program and stimulus package. Again the Fed is using the equivalent of steroids – lots of it. In doing so, it is doing exactly what it did last time – only on a much larger scale. The result may be the same. In order to prevent a huge crisis today, the Fed is sowing seeds of a catastrophic crisis in 2015...




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This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.