Even after the Fed began raising interest rates in 2004, money was still pouring in from abroad, fueling a consumer spending boom without precedent.

When the credit bubble burst in 2007 and 2008, many blamed the complex new financial instruments that made the mortgage boom possible — in addition to the failure of risk-management models, or even the role of ratings agencies. But in the end, it was the central banks that had to take ultimate blame, mainly for allowing interest rates to be less than the inflation rate — sometimes referred to as negative real interest rates.


What are real interest rates?

Think of Alice in Wonderland's looking glass — where things are not what they appear to be. Real figures, such as real interest rates and real wages, tell us what the figures really are when adjusted for inflation. It means nothing to say you're earning 10 percent interest on your bank deposits when inflation is several points higher and, at the end of the day, you end up losing money in real terms. During periods of insignificant inflation there is no difference between nominal financial figures and real figures. But when inflation grows it's important to compare all figures to the rising cost of goods and services. It may be better to borrow rather than save during periods of low or negative real interest rates, for example. And real wage growth is much more relevant than nominal. If you get a 5 percent raise during a year when prices rise by 6 percent, you've actually taken a pay cut.

Faced with global crises, central bankers often face a serious quandary. Just as they were tested by the collapse of Long-Term Capital Management, the Russian debt default, and the Asian crisis of the previous century, the central bankers in the 21st century have to carefully weigh their twin duties of safe-guarding stability and fighting inflation. The question is: How far can you go in preserving financial stability — bailing out failed banks and investors, for example — before you run the risk of encouraging further abuses or the creation of more market bubbles?

It is a difficult task. Because the benefits of recession — purging the excesses of an overheated economy, for example — may outweigh the costs: unemployment, lower wages and profits, rampant bankruptcies. Joseph Schumpeter, a visionary economist of the early 20th century, saw a sort of “creative destruction” taking place during an economic downturn, where capital would be freed up — removed from dying enterprises to give life to new ones.

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