Sunday, December 7, 2008

Deflation Virus

Nobel Laureate Robert Mundell warned last week that America faces disaster unless the Bernanke policy is reversed immediately. This is a minority view, but one held by a disturbingly large number of theorists. History will judge.

Henry Kaufman, former economist for Salomon Brothers, said, "we’ve got to kick our addiction to debt if the world is to regain some semblance of financial sanity." Source

"It is the United States as a whole that became addicted to spending and consuming [and borrowing] beyond its capacity to produce," Volcker lectured the Economic Club of New York in April. "It all seemed so comfortable." Source

Nobel Laureate, Joseph Stiglitz says, Keynes argued not only that markets are not self-correcting, but that in a severe downturn, monetary policy was likely to be ineffective. Fiscal policy was required. But not all fiscal policies are equivalent. In America today, with an overhang of household debt and high uncertainty, tax cuts are likely to be ineffective (as they were in Japan in the 1990s). Much, if not most, of last February’s US tax cut went into savings.

Stiglitz goes on to say [to condemn the Paulson/Bernanke bailouts] preserving financial institutions is not an end in itself, but a means to an end. It is the flow of credit that is important, and the reason that the failure of banks during the Great Depression was important is that they were involved in determining creditworthiness; they were the repositories of information necessary for the maintenance of the flow of credit. But America’s financial system has changed dramatically since the 1930s. Many of America’s big banks moved out of the “lending business” and into the “moving business”. They focused on buying assets, repackaging them and selling them, while establishing a record of incompetence in assessing risk and screening for creditworthiness. Source

Fischer Black began thinking seriously about monetary policy around 1970, and found at this time that the big debate in this field was between Keynesians and monetarists. The Keynesians (under the leadership, at that moment, of Franco Modigliani) believe there is a natural tendency of the credit markets toward instability, toward boom and bust, and they assign to both monetary and fiscal policy roles in dampening down this cycle, working toward the goal of smooth sustainable growth. In the Keynesian view, central bankers have to have discretionary powers to fulfill their role properly. Monetarists, under the leadership of Milton Friedman, believe that discretionary central banking is the problem, not the solution. Friedman believed that the growth of the money supply could and should be set at a constant rate, say 3% a year, to accommodate predictable population growth.

On the basis of the capital asset pricing model, Black concluded that discretionary monetary policy could not do the good that Keynesians wanted it to do. But he also concluded that it could not do the harm monetarists feared it would do. Black said in a letter to Friedman, in January 1972:

In the U.S. economy, much of the public debt is in the form of Treasury bills. Each week, some of these bills mature, and new bills are sold. If the Federal Reserve System tries to inject money into the private sector, the private sector will simply turn around and exchange its money for Treasury bills at the next auction. If the Federal Reserve withdraws money, the private sector will allow some of its Treasury bills to mature without replacing them. Source