Congressman Ron Paul is one quirky cat.
I can't say that I agree with him when it comes to his calls to abolish the Federal Reserve, and I'll admit to giggling sometimes when he makes off-the-wall comments. However, I do listen intently when he gets a chance to question Fed Chairman Ben Bernanke, because his pointed challenges of the Fed and Fed policy can stir up some interesting discussion (as opposed to the snooze-inducing dreck that often permeates governmental hearings).
Yesterday, Paul challenged Bernanke on whether the extended period in which the Fed kept rates low at the beginning of the decade led to the housing and credit bubbles. His questioning became the latest reverberation of the "too low too long" debate.
Why "too low too long" matters
In the eyes of economists, all of us react to various economic incentives. As a driver of interest rates, the federal funds rate is a key variable in encouraging people to act a certain way.
Think about it this way: If a low federal funds rate pushes down borrowing costs for JPMorgan Chase
That one purchase may not make a huge difference, but multiply that over a whole bunch of consumers, and you may be moving a serious number of TVs. Best Buy, for its part, may decide that this increase in demand requires new stores, which, by the way, can be financed with low borrowing costs.
Those new buildings could be part of an overall boost in steel demand for manufacturers like Nucor
All of that comes back to incentives. If interest rates are held too low, they can artificially increase demand, encourage companies to produce based on that heightened demand, and get banks to lend to all sorts of borrowers who shouldn't be borrowing. In short, unnaturally low rates could throw the whole system off kilter.
Supporters of the "too low too long" argument would say that the mess we've seen with homebuilders like Toll Brothers
No easy answer
Paul's volley about "too low too long" is hardly the first. Debate still percolates about not only whether rates were kept too low, but if they were, whether they really could have caused the housing bubble.
Besides Bernanke, one economist who's been front and center in the debate is Stanford professor John Taylor. He's particularly notable here because he cooked up the so-called "Taylor Rule," an equation based on inflation and the gap between current economic production and "optimal" production that spits out a recommended federal funds rate target.
Taylor and Bernanke have been at odds over the best way to use the Taylor Rule in guiding the Fed in policymaking decisions. While Taylor sticks to the method he's always used to calculate the optimal target rate, Bernanke and the Fed have been following a slightly tweaked version that uses different constants and forecast (instead of current actual) inputs.
The debate may sound a bit dry and academic, but the implications are anything but. Over the past year, calculations of the Taylor Rule by the Fed have been significantly different than what Taylor's approach would come up with. That is moot for now, because both have had negative results, and the Fed can't drop rates lower than zero.
However, as inflation begins to rise and the economy continues to recover, those disparate conclusions could potentially mean big differences in the way policy is carried out. And if you believe that rates were kept "too low too long" the first time around, it could mean playing that same record all over again.
So what do you think? Were rates kept "too low too long" the first time around? Will the Fed fall into that trap this again? Scroll down to the comments section and share your thoughts.
Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool. The Fool’s disclosure policy assures you no Wookiees were harmed in the making of this article.