Sunday, January 24, 2010

Imagine the financial economy as an Olympian realm, residing in the clouds, where traders play with financial assets, and Zeus-like, bored, come down to earth and mate/create mischief. You see it in the papers, when somebody builds a four-lot single-family house in a prime location in a major city. You see it in a bar, when a trader snags a beautiful, classically educated Yalie. However, doing this takes than a half percent of their assets -- the rest of their assets continue to float around in the financial economy, because, in that economy, they get returns of more than twenty per cent per annum.

So the financial economy -- where centimillionaires and even billionaires, insulated from the prying eyes of the Forbes 400 list by layers of discretion -- has this incredible concentrated power -- liquidity -- that does not disrupt the real world as long as it stays in its universe. The commodity bubble in the Summer of 2008, when the financial economy completely disrupts the real world, and temporarily doubles food prices on the whole planet, but then the bubble bursts when the financial economy realizes that people cannot afford to pay double prices to eat.

But where does all that money come from? Mostly it is created by central banks, keeping interest rates low, so money-center banks can take profits and avoid losses since it costs them nothing to hold losses on their books. Keeping interest rates low allows Obama to present the fiction that insolvent banks are doing fine.

Other than bank failures, what would happen if the Fed started raising rates? Money would shift into the real economy, with the immediate consequence that wage-earners would be competing with all this extra money for the same goods in the universe. And that would economic dislocation -- the equivalent of reducing most people's pay by half or two thirds -- would have immediate political consequences.

And, that of course, is why the Fed is keeping rates low, and why Obama is not earnestly trying to shut down the financial party. When the party is shut down, the revelers would stream into the village, but the longer they spend in their own world, the more disruptive they will become when they merge with ours.


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