Tuesday, 17 August 2010

The Fed can't solve our economic woes

is what Gerald P. O'Driscoll Jr. tells us in the pages of the Wall Street Journal. O'Driscoll opens by saying,
A policy of low interest rates is a textbook response of monetary authorities to the economic weakness brought on by deficient aggregate demand. The policy is justified by pointing to various ways in which money can promote economic activity—including by stimulating investment, discouraging savings, encouraging consumption spending, and allowing individuals to lower their debt burdens by refinancing existing debt. While these effects are theoretically plausible, this textbook policy does not apply to our present situation.
He goes on to note,
First, our lingering crisis and economic weakness was brought on not by a Keynesian failure of effective demand, but by a Hayekian asset boom and bust. Second, the textbook case for low interest rates treats the policy as one of benefits without costs. No such policy exists.

The housing boom and bust was a classic asset bubble, such as occurred frequently in the 18th and 19th centuries. Easy money working through cheap credit made long-term investments appear more valuable than would otherwise have been the case. In most cases, investment booms drive industries with sound fundamentals. When the cheap credit keeps flowing, however, fundamentals are forgotten and the process evolves into a mania (to use the old-fashioned term). What cannot be sustained will not be, so the boom ends in a crisis.

In these scenarios, the collapse of demand is a consequence—not the cause—of the bust. Policies to address crises must get cause and effect right.
The financial panic and ensuing great recession was a classic balance-sheet recession. As balance sheets shrank in value, demand collapsed. There was a liquidity crisis as well, centered around Lehman's collapse, but the driving force was collapsing balance sheets, impaired capital values and, for many, insolvencies.

The declines in home values, investor portfolios and 401(k) plans, and the uncertainties surrounding retirement plans, have all had a big impact. The solution lies in restoring balance sheets. For financial firms, that means raising capital. For consumers and businesses alike, that means saving more of their reduced incomes.
He continues,
What is in short supply is not liquidity, but savings. The Fed can supply the former but not the latter.
and goes on to say,
[...] historically low interest rates—about which the Bank of International Settlements, the bank for central banks, sounded a warning in its 2009/2010 annual report—will inevitably distort economic activity, as they did during the housing boom. Low interest rates slow the process of restoring balance sheets by keeping asset prices artificially inflated. They also penalize saving, thus prolonging the process of rebuilding balance sheets.
O'Driscoll ends by saying,
Markets are resilient, but their recovery can be impeded by bad policies. At present, both monetary and fiscal policies are on the wrong track.
Add to this the moral hazard problems that the handling of the crisis has created and we can rest assured we're not about to see an end to current problems any time soon.

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