See my new Forbes column on the puzzling economic outlook and a new way to think about monetary policy . . . .

Some excerpts:

Before saying the real problem is we are not providing enough monetary stimulus, should we not worry about why corporations did not invest then and what other problems will emerge as we  keep rates ultra-low while hoping corporations will see the light?

. . .

If the government raised taxes explicitly to provide the interest subsidy, everyone would scrutinize the use this money was being put to carefully. Because the Fed picks investors’ pockets silently and forcibly through its ability to set the short term interest rate, no one asks questions about cost.

. . .

Of course, the Fed now disingenuously claims that the worst excesses in the housing market were committed when it had already started raising rates, and therefore it is not responsible for the housing boom. But it was complicit in setting off the boom by keeping interest rates too low for too long before then!

I may disagree with Rajan’s take on “global imbalances” (as I wrote about here) but nevertheless think he has become one of the smartest academic analysts of today’s confusing economic landscape.

“We should face the evidence that we are no better today at predicting tomorrow than we were yesterday. Eighty years after the Great Depression we still argue about what caused it and why it ended.

“If economics is a science, it is more like biology than physics. Biologists try to understand the relationships in a complex system. That’s hard enough. But they can’t tell you what will happen with any precision to the population of a particular species of frog if rainfall goes up this year in a particular rain forest. They might not even be able to count the number of frogs right now with any exactness.

“We have the same problems in economics. The economy is a complex system, our data are imperfect and our models inevitably fail to account for all the interactions.

“The bottom line is that we should expect less of economists. Economics is a powerful tool, a lens for organizing one’s thinking about the complexity of the world around us. That should be enough. We should be honest about what we know, what we don’t know and what we may never know. Admitting that publicly is the first step toward respectability.”

— Russ Roberts, February 27, 2010

— Nassim Nicholas Taleb, AI5000, Jan/Feb 2010

Economist David Malpass, however, had the whole thing nailed back in 2002. Here’s Malpass in a note today:

Today’s New York Times front page has a David Leonhardt article on the Fed entitled “If Fed Missed Bubble, How Will It See New One?”  It criticizes Chairman Bernanke’s Atlanta speech: “This lack of self-criticism is feeding Congressional hostility toward the Fed.”

I’ve attached my 2002 WSJ article on the same topic (The Fed’s Moment of Weakness).  It argued that Chairman Greenspan was “letting himself off the hook” in 2002 by saying that the Fed couldn’t anticipate asset bubbles. The 2002 article concludes that: “If the value of the dollar is allowed to fluctuate as wildly in the future, then momentum will dominate the global economy as it did in the 1990s, creating constant boom/bust cycles.”

We expect Chairman Bernanke to be reappointed and the Fed’s lagging monetary policy to continue for at least one more cycle.  For now, this feels good to financial markets (everything is up today except the dollar — gold, oil, the euro, U.S. equities and especially foreign equities in dollar terms.)  However, this gradually channels capital away from the U.S. and especially from the many small businesses (and yet-to-be-created businesses) left out of Washington’s aggressive credit rationing process.  This undercuts U.S. growth and leaves unemployment much higher than it should be.

We often say hindsight is 20/20. Monetary policy is in a sorry state when the hindsight of the insiders lags the foresight of the outsiders. By eight years and counting.

(My own contributions to the debate here and here.)

— David Malpass, August 20, 2009

Now, in a new article, Reynolds’s colleague Brink Lindsey teases out many additional unappreciated factors in the apparent recent increase in wage inequality. Among the most important overlooked factors is the huge influx of immigrants over the relevant period:

Just two months after signing the Voting Rights Act, President Lyndon Johnson signed the Immigration and Nationality Act of 1965, ending the “un-American” system of national-origin quotas and its “twin barriers of prejudice and privilege.” The act inaugurated a new era of mass immigration: Foreign-born residents of the United States have surged from 5 percent of the population in 1970 to 12.5 percent as of 2006.

This wave of immigration exerted a mild downward pressure on the wages of native-born low-skilled workers, with most estimates showing a small effect. Immigration’s more dramatic impact on measurements of inequality has come by increasing the number of less-skilled workers, thereby increasing apparent inequality by depressing average wages at the low end of the income distribution. According to the American University economist Robert Lerman, excluding recent immigrants from the analysis would eliminate roughly 30 percent of the increase in adult male annual earnings inequality between 1979 and 1996.

Although the large influx of unskilled immigrants has made American inequality statistics look worse, it has actually reduced inequality for the people involved. After all, immigrants experience large wage gains as a result of relocating to the United States, thereby reducing the cumulative wage gap between them and top earners in this country. When Lerman recalculated trends in inequality to include, at the beginning of the period, recent immigrants and their native-country wages, he found equality had increased rather than decreased. Immigration has increased inequality at home but decreased it on a global scale.

In sum, immigration has been mostly good for overall U.S. economic growth and for the immigrants themselves, whose “low” U.S. wages are dramatically higher than were their home-country wages. But immigration has altered the statistics of aggregate “inequality” in a misleading way, rendering much of the debate moot.

Why is it that people know so much about something so small (GDP) but so little about something so big (total assets)? I think it is because since the 1930’s macroeconomics has developed into a discipline concerned almost exclusively with who is spending how much money. Very little attention is paid to the capital base, or balance sheet, that makes it possible to produce the goods and services measured as GDP.

Rose: “Looking back, what are the mistakes, and what should you have done more of? Where were your instincts right but you didn’t go far enough?”

Geithner: “There were three broad types of errors in policy. One was that monetary policy here and around the world was too loose for too long.  And, that created just this huge boom in asset prices; money chasing risk; people trying to get a higher return; that was just overwhelmingly powerful.” 

Rose: “Money was too easy.”

Geithner: “Money was too easy, yeah . . . . Real interest rates were very low for a long period of time . . . .”

There you have it. Pretty simple. And yet it is the first time I can recall that any U.S. executive branch official, spanning the Bush and Obama Administrations, has admitted monetary policy was even one factor, let alone the central factor, leading to the crash. This is very big stuff.

Some of us have been saying this for years, and even warned of the potentially severe consequences as the monetary errors were building. Few predicted the exact course of extraordinary events over the last 18 months, but it was clear to me in August 2006 the size of the monetary mistakes would have big repercussions:

It is these periods of transition, where the value of the currency is changing fast, but before price changes filter through all commerce and contracts, when financial and political disruptions often take place.

So Geithner, who’s had some rocky moments, gets real credit for admitting a crucial and central truth of this historic economic event, heretofore banished from polite conversation by an omertà of the economic brethren.

Yet why, among the endless lending, spending, and Tarping (unending?), does monetary policy not even get a mention when we talk about building a more robust economic system for the future? Obviously the Fed and Treasury are taking unprecedented and, I would even say, bold and creative actions to relieve the immediate crisis.

But when we contemplate a new financial order, when the the G20 meets in London to supposedly consider a Bretton Woods II, when economists begin revising their models of risk and politicians fantasize of new regulatory strictures on banks, hedge funds, investors, and lenders — when we gab about full-proof prevention of such trauma in the future — why do the key players neglect to even gently raise the “overwhelmingly powerful” central error of the whole episode?

New computer models. International super-regulators to spy and pierce bubbles. A rich new slush fund for IMF bureaucrats. Austere new pay limits for private finance. Cramming down mortgages. Propping up banks. All talk of money. Yet no mention of . . . the dollar.

Credit’s fiercest disciplinarian is sound money. The best regulator of risk is a stable currency. Far more than the new policy contraptions proposed by Davos dreamers and Gaussian copula critics, it is the elemental simplicity of a low-entropy dollar that can once again be the steadfast foundation for dynamic creativity and the measuring stick and promoter of real economic value.

(Hat tip: Social Security Institute)

UPDATE: See The Wall Street Journal’s excellent editorial on this important concession.