The Gold Standard  

Recently, I came across the following observations in a research note provided by a vendor:

Some have blamed the Federal Reserve for inflating yet another asset bubble. If this is the end result, so be it. Debt deflation and the associated recession are rooted in a balance-sheet crisis. As such, the remedy must be oriented toward addressing balance-sheet stress. The only effective way to alleviate balance-sheet stress is to lift equity prices, even at the risk of creating another asset bubble. One could argue that this a short-term quick fix that will sow the seeds of the next destruction. May be it is bad policy, but for now the alternatives are even worse.

The Austrian school approach is idealistic and not at all practical. It was tried in the 1930s and failed miserably, wiping out nearly one third of the Western world’s GDP. Also, over a quarter of the labor force was thrown onto the streets. The slogans at the time were “liquidation” and “thorough cleansing”. The system had indeed been thoroughly cleansed, but the economy was almost “cleansed” to death. No serious policymaker today will want to repeat the same experiment”.

It is not important to know who wrote this for that would detract from the discussion of the point and divert our attention on to the protagonist.

These are very interesting and normative observations. The dispute as to which approach is right is unlikely to be over with this crisis. There is one strong argument in favour of what this writer has said. If crises are rooted in human nature and hence, endemic, there is no point in trying to forestall crises. By definition, one cannot. Therefore, the correct attitude is to deal with the fallout of the crisis and that is what policymakers have done.

The counter-argument runs as follows: Crises might be endemic and intrinsic to human nature but policymakers can still achieve two things: they may not be able to pre-empt crises but they can pre-empt the degree of destruction by leaning against the wind when the pre-crisis boom is sowing the seeds of the crisis. Second, by allowing the pain of crisis to be felt and fixing responsibility for it, they can extend the gap between two crises.

Recent economic history favours this counter-thesis. The 18-year boom that started in 1982 was perhaps due to the aggressive and painful high interest rate medicine of Mr. Paul Volcker in the U.S. that wrung out high inflation and set in motion a long-term trend decline in interest rates and cost of capital. Per contra, the green-signal that Mr. Greenspan gave to fiscal stimulus of the previous U.S. administration and his low-for-long interest rate policy gave rise to a pyrrhic recovery in 2002 that peaked in 2006, busted in 2007 and morphed into a full-blown crisis in 2008. No one can argue that America’s 17.5% unemployment rate (including underemployed and discouraged workers) is the outcome of following Austrian policies!

Of course, both arguments are made with the benefit of hindsight and without possible recourse to counterfactual scenarios. In the final analysis, when it is possible that ‘in a low-growth world without an intervener of last resort, conflicts of all kind could be on the rise’,  it is unsurprising that the ‘pain first and gains later’ prescription has few takers in the political and policy space.

That does not mean that all those who warn of the consequences of such an approach are hypochondriacs.

Postscript: I came across this timely post in Macroman blog. This parting observation of the blogger deserves a special mention:

Still, if Kohn’s claim that “our abilities to discern the “correct” values of assets is quite limited”, how can the Fed fail to recognize that Nasdaq 1999-2000 was a bubble….
…as was the 2003-05 housing market…..
…and oil last year…..
…but that a less than 10% decline in the value of the S&P 500 in the first few weeks of last year was sufficiently worrisome that it merited a 75 bps inter-meeting cut a mere 8 days before a regularly scheduled FOMC policy decision (which produced a further half-point cut.)?

Put another way, why does the Fed feel powerless to identify bubbles in real time, but is evidently highly confident in its ability to determine when asset prices have fallen below equilibrium?

If the Federales are truly concerned about ensuring financial stability, addressing asset price moves in a symmetric fashion would be a great place to start. Because on the evidence of the last dozen years or so, the Greenspan/Bernanke/Kohn is a helluva lot more trouble than it’s worth.