So Paul Krugman gets a lot of ink, and everyone goes gaga for it. I don’t buy his arguments for two reasons:
- He misdiagnoses the cause of the current crisis. He thinks it is too much of the “free markets.” Rather, it was predominantly profligate monetary policy. Secondarily, it was poor banking regulation. Monetary policy necessarily involves banking regulation in a fiat money system, because credit is what drives the economy. A failure to limit the ability of regulated institutions to issue credit is just another form of loose monetary policy, whether it results in measured price inflation or not.
- Keynesian economics and Neoclassical economics do not consider the debt structure of the economy to be relevant for policy purposes. I’ve written about this already in this blog post: Waiting for the Death of the Chicago School, and the Keynesian School also. Debt structure is more relevant than any other factor at present. Economies with high levels of indebtedness are inherently fragile, because booms and busts are amplified by the financial leverage.
Let me take this a different way. If monetary policy had been conducted properly through the Greenspan era, what should he have done? Let’s start with the crash in 1987. Greenspan should have done nothing — no announcement at all. Maybe a few small clearing firms would have failed, and maybe some minor investment banks, but so what? The economy would remain sound. There would be little danger of an increase in unemployment.
Instead, he announces support for the markets, and debt levels increase as a result. Bad debts are not liquidated, and new debts are incurred, because policy is favorable toward debtors.
Next came the commercial real estate crisis of the late ’80s to early ’90s. What did the Fed do? It cut rates from 9.75% to 3%. What should it have done? I have a basic rule that says that the Fed funds rate should never be more than 1% below the yield on the 10-year Treasury. That means the Fed should have leveled out the Fed funds rate at 6-7%, and waited, and taken political heat for doing so. If they had done this, there not would have been a residential mortgage convexity crisis in 1994, which ended up sinking Mexico as well.
Why not less than 1% below the 10-year Treasury rate? Anything more leads to easy profits for the banks, with a large increase in the indebtedness of the economy. Let the banks remain on a diet, and let savers get their due reward. We don’t have to flood the economy with liquidity to get it to turn around. Enough liquidity and willingness to wait will do it. A policy approach like that will lead to a more stable and yet growing economy.
So what was the next crisis? LTCM in 1998. The Fed should have done nothing, and if any or all investment banks failed, it would have had little impact on the economy as a whole, because derivative exposures were small. But no; they coerced the investment banks into a settlement, and loosened the Fed funds rate 0.75% when it should have kept policy tight, and not loosened at all, staying at 5.5%.
Perhaps the tech bubble would have been less virulent if liquidity had not been so plentiful. Between the loosenings during LTCM and the extra build-up in liquidity for Y2k, the Fed put in the top of the equity market. Then the Fed tightened significantly, bursting their new bubble. After that, they went nuts, loosening Fed funds from 6.5% to 1.75% by the end of 2001. It probably should have stopped at 3-4% and waited. But no, not only did they go down to 1.75%, they went all the way down to 1% in June 2003, when it was obvious that a strong recovery was underway, and the FOMC left the rate there for a full year, while asset inflation springing from additional indebtedness coming from cheap financing ruled.
Instead of moving from 1% to 4% rapidly, the Fed chose a slow pace, a robotic pace for the next 17 meetings, increasing 0.25% each meeting. Language dominated over policy as the market anticipated their actions. They dared not surprise the market, but they overshot the 4% area that would have been closer to equilibrium.
If the Fed is unwilling to deliver surprises, it is unwilling to govern. Give us what we need, not what we want. At present, Fed funds should be in the 3% region, allowing a slightly positively sloped yield curve, which would allow most banks to do well in a normal environment.
What’s that you say? It’s not a normal environment now, so why should the curve be flatter? It is not a normal environment now precisely because the Fed was so loose for so long, allowing a huge buildup of debt that we are now fitfully trying to liquidate. When that debt gets down to 1.5x GDP, we will have robust growth once again. In the 3.0x+ position that we are now in, there is little hope for significant growth rates. Our government should be aiding in liquidating zombie institutions, rather than keeping them undead with cheap financing.
Consider the position of David Walker. He knows how bad the total debt crisis of the US is. I’ve written about this many times before; this is the latest example. Keynesianism does not address sovereign indebtedness, which is a huge flaw. What if a country can’t make good on all of its promises? Were the US not the global reserve currency, that would be a big problem for us now. Deficits are not helping the UK or Japan now. But what happens when we go into perma-deficit in the next few years, where there is little to no hope to paying off debt, because excess revenues on social programs evaporate, and the elimination of deficits relies on the willingness of the US to raise personal income taxes across the board. Soaking the rich will never be enough, and they always find ways of sheltering income. Who will be willing to pick up the knife, and proudly say to constituents, “I did what was right for you and raised your taxes?” or, “I did what was right for you and cut social security payments by 30%, and created a 30% copay on Medicare.” or, “I helped create a new chapter in the bankruptcy code for states, with a modification to ERISA that allows for lowering of pension and healthcare benefits paid to former state employees for states under financial stress.” No one will say any of that, obviously.
Perhaps there are simple solutions to all of this. The only one I can think of is a large rise in taxes, which would be bitterly opposed, and might not result in that much additional taxes. Any other bright ideas out there?
One final comment on the failure of macroeconomics — consider who did peg the crisis in advance. Most were practical, business-oriented economists who saw the growth in leverage, and said, “This will not end well.” The trouble is that timing and estimation of severity of the then-future crisis were problematic. The moment that you say “This end badly,” in the midst of the bull phase, you can get labeled a perma-bear. I hated that title, so I would tweak my language to avoid sounding too harsh. Today that’s a pity, because the scenarios we privately talked about at my last employer are what are playing out now.
Why did macroeconomics fail us? Bad theory in the two main schools of Neoclassical economics — Chicago and Keynesian. There was an inability to appreciate the effects of overindebtedness on an economy. Time to send both schools to the junkyard.
PS — I saw this in Barron’s. If Henry Kaufman’s book is as good as it sounds, perhaps it will provide more insight into this situation.