Tuesday, November 10, 2009

Some honest answers

Excerpts from, It Hurts When I Do This….. by Joseph Y. Calhoun, III

A quote widely credited to Albert Einstein is that insanity is doing the same thing over and over and expecting different results. If that is true, the politicians and Federal Reserve governors who craft economic policy qualify as certifiable. Certain policies have been proven to produce inferior economic results, yet every few generations our collective memory seems to fail us. Apparently some economic lessons can only be learned through first hand experience. Sometimes, it doesn’t even take that long and we repeat the same mistakes during the course of one generation. The Baby Boom generation seems particularly vulnerable to memory lapses when it comes to economic policy. Well, they told us the sixties would have side effects….

By my count the financial crisis that brought the economy to its knees last fall was at least the ninth since the founding of the republic. While there are differences in the causes and effects of these crises, there are also common elements, the most prominent of which is the centrality of the banking system to nearly every economic crisis in our history. One would think that somewhere along the way someone in power would have put an end to the financial industry’s penchant for self destruction, but the financial oligarchy and its influence over government has a long history in the US.

Since the formation of the first Bank of the United States, the financial industry has sought - and usually gained - privileges and advantages not enjoyed by the rest of the citizenry. These special privileges, when combined with other government policy, tend to produce booms and busts. In this crisis we can point to the role of the Federal Reserve, Fannie Mae, Freddie Mac, CRA and HUD. In the panic of 1819 the culprits were the Second Bank of the United States and the sale of public land by the government. Credit expansion and government endorsed liberal borrowing terms had the same effects then as now and eventually the boom of the post war (of 1812) period turned to bust. It should not surprise anyone that the boom period also saw the establishment of the New York Stock Exchange and a rapid rise in commodity prices. Speculation, whether in real estate, stocks or commodities, is a direct consequence of monetary expansion.

The difference between the current episode and the earlier versions is the development of the systemic risk, too big to fail doctrine. In older times, banks that got into trouble were allowed to fail and the system generally healed itself fairly quickly. And while there were often calls for debtor relief as there are today, these calls generally fell on deaf ears. Debtors were forced into bankruptcy and debts were written off as banks failed. Depositors, bond and stock holders were forced to take their losses. And, purged of the excess debt, the economy recovered primarily of its own accord. That isn’t to say the recoveries were painless; unemployment was high during the depressions and there was essentially no social safety net outside private charity. But despite the pain, the economy recovered every time even though the Keynesian prescription of government spending was rarely if ever employed prior to the Great Depression. Capitalist economies, when left to their own devices, are amazingly resilient.

So we go through these excess exuberance episodes, crash and recover and then promptly forget what caused the whole mess. It doesn’t take great insight to determine the common factor. Excess money creation, generally in the form of excess credit creation, is the root cause of all the financial panics in the history of the US. The crash generally comes as the excesses are finally recognized and the political authorities attempt to force a return to sobriety. The specific circumstances of the series of crises that started with the panic of 1819 may differ, but the common feature, in one form or another, is inflation of the money supply. It really is that simple and if we want to prevent future crises, that is the one item we have to address. Systemic risk regulators and consumer financial protection agencies are just window dressing if the reforms enacted as a result of the panic of 2008 don’t include measures which prevent excessive credit creation by the banking system and excessive money creation by the Federal Reserve. . .

Since Alan Greenspan assumed the reins of the Federal Reserve, our economy has seen a series of bubbles caused and burst by the Federal Reserve. Volatile monetary policy in the 1980s, which is obvious from the extreme fluctuation in the value of the dollar, produced a stock market and real estate crash. The result was the S&L crisis which produced the easy monetary policy of the early 90s which directly led to the stock boom of the late 90s. The stock market crash of 2000 produced the easy monetary policy of the early 00s and the subsequent real estate bubble. And now, after the financial implosion of last fall, the Federal Reserve is once again pursuing the same loose policy which produced all these previous problems.

What caused the Great Moderation was not superior monetary policy. The Great Moderation could be more accurately called the Great Leveraging. Every economic hiccup was met with another dose of credit. As the debt level rose, each cycle took more debt and lower interest rates to cause a recovery in GDP.

So now we find ourselves in a situation where the Fed can’t lower rates any more and individuals can’t take on more debt. For now, the government has assumed the role as borrower and spender of last resort and the Fed has resorted to extraordinary measures to increase the supply of credit, but this is not a serious long term solution. We are rapidly approaching the point where we will not be able to increase our debt level. We can either wait until that point is reached and a solution will be forced on us by our creditors or we can start to really solve our debt problems now. It is time for the Great Deleveraging.

It needs to be said that there is no painless solution for our economic problems. There are a number of paths we can choose from here but all of them involve pain. Like everything else in economics the choices we face will involve tradeoffs. If we choose to pursue policies which reduce the economic suffering in the short term, the duration of the suffering will be extended. If we choose to pursue policies which quickly solve the problem, the short term suffering will be severe.

What are our choices? Well, as most of you know, I consider myself a libertarian so my solution is stop doing the things that cause us economic pain. Excess debt and easy monetary policy are what got us here. If we cut government spending to balance the budget and stabilize the value of the dollar, I think real growth - as opposed to the false growth of last quarter - will be restored fairly quickly. It would be even better for growth if we could cut taxes as well, but I think it is more important to show that we have a credible plan for reducing our debt and cutting taxes would send the wrong signal right now.

No country with an excess debt problem has solved it by borrowing more and neither will we. We will not default and inflation is not really an answer. We may be able to engineer another recovery based on more debt, but that will ultimately just make the debt problem larger. It is time to face the music and finally solve our debt addiction. If doing something repeatedly hurts….stop.


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