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Yellen Ponders Policy as Politicians Ponder Deal

12:00 AM, Oct 26, 2013 • By IRWIN M. STELZER
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Yellen’s guess will rely heavily on her own formidable scholarship and on the Fed’s economic model. Which presents her with still another complication. Alan Greenspan, who filled the Fed chair from 1987 t0 2006, has unburdened himself of doubts as to the usefulness of the Fed’s forecasting model. When chairman, Greenspan questioned whether “bubbles” exist, and claimed he would have no way of recognizing one if it did appear. After all, prices set in markets—including house prices—represent rational decisions by buyers and sellers, funded by rational bankers. Now, in his new book, The Map and the Territory, Greenspan says he failed to take sufficient account of the work of behavioral economists who are finding wisdom in what Charles Mackay in 1841 called “extraordinary popular delusions and the madness of crowds,” and Greenspan himself once called “irrational exuberance.” Such delusions and irrationality, he now thinks, can create booms and busts in asset prices—most notably shares and house—that current models cannot predict.

Yellen will, in the words of then-judge William Howard Taft (penned in 1898), be setting sail on a sea of doubt, steering QE3 by an imperfect model at a time when:

·     fiscal policy is tightening,

·     the unemployment rate is coming down only because the labor force participation rate is at its lowest level in 35 years,

·     the employment effects, if any, of Obamacare have yet to become clear,

·     the dollar is weakening, adding to inflationary expectations.

And another brawl over the debt ceiling is scheduled to reach a climax on February 7, although imaginative Treasury juggling can push that date back to April Fool’s day. So B.B. King, who was right that the thrill is gone, was wrong when he added, “It’s gone away for good.” We’ll be back at the brink soon after we unwrap our Christmas presents. 

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