The echo effect and the current economy

The echo effect is a well know phenomena in many sciences. Some shock to a system may dissipate through time but may cause secondary effects as the initial impact moves through time and disrupts other parts of a system. You get feedback and distortion. Think of the old wave machine in physics where an initial wave will have new and more complex effects as it comes in contact with other objects. This stylized idea of echo effects and the timing impact of shocks and the subsequent reaction is a concern in the current economy.

The problems of 2007 and 2008 are a result of the action from the last bubble in 2000. The dot.com debacle caused a Fed monetary policy reaction of lowering interest rates to maintain economic growth. The 2001 recession was short-lived because of the swift and strong reaction of the Fed. This set-up the housing market excesses between 2002 and 2007. With rates taken down to such low levels, it was inevitable that some borrowers and lenders would try and exploit the attractive rates and increase leverage.

Given rates were set at lower levels and never really had a chance to grow to the levels that would reduce housing speculation, the US economy’s current problems were potentially exacerbated. The Fed again lowered rates in 2007 but from a lower starting point. We are now at 2% Fed funds but our policy choices are now restricted. This is no different from what happened in Japan during their “lost decade”. A reaction to the first downturn caused limitations in policy choices later on. However, in the case of Japan, the lack of swift action meant a deeper problem later. In the case of the US, swift reaction during the dot.com debacle has generated over speculation in other markets which have to now be dampened. We are affected by our past choices.