Tuesday, March 25, 2008

The Fed’s bubble policy

The record of the Greenspan era’s Fed in conducting monetary policy repeated a simple behavioral formula: a crisis to which the Fed reacted by swiftly and aggressively cutting its steering rate of interest that quickly increased liquidity in the financial system; in between the crises Wall Street was given a loose rein to trot.

Ben Bernanke’s Fed is a similar addict. Why?

Over two decades the whole world experienced an exceptionally loose monetary policy that kept both nominal and real rates of interest historically low in the developed countries. Central banks allowed the stocks of money and credit to grow too fast for too long that induced the agents to chase returns everywhere and in any possible asset, dismissive from the risks involved. That pumped the prices of equities, bonds and houses up. The whole world lived in an enormous liquidity bubble in which the pricing of risks was distorted.

The disequilibrium created two forces that are in effect during the process of adjustment that started about a year ago.

The prices of goods and services are closing “normal” their gap to asset prices that sped up the rate of inflation.

An increased appreciation of investment risks brought about a decline of private sector asset values and, in particular, the market prices of the assets that represent claims to the original assets. It causes debt deflation that will freeze up the whole financial system.

Such a destructive spiral was experienced in Finland during the years of 1991-1993. The agents’ attempts to pay off their debts were eroded by declining asset values, creating negative equity. That decreased spending and production, causing massive credit losses in the banking sector, after the collapse of the fixed exchange rate regime in particular. The bail out of the banks, their depositors and international financiers cost 8 per cent of the year 1990 GDP to the taxpayers. In addition, the banks themselves digested credit losses equivalent to over 6 per cent of the 1990 GDP.

The Fed regards the force of debt deflation as a much greater peril than the threat of quickening inflation. That is why it chose to lean on the proven drug, in a way, giving support to the top level players of the financial system.

Does an alternative medication exist? Perhaps not, after the crisis erupts.

But, before the event there are many preventive cures from an explicit inflation target in the medium term to classical surveillance of money and credit stocks. Will the Fed be the first to also weigh asset prices in its inflation target?

Some observers always recommend tighter regulation of the financial system. John Maynard Keynes - in the final chapter of his 1939 edition of The General Theory of Employment, Interest and Money – conceived “a somewhat comprehensive socialisation of investment” and the State being able to determine “the basic rate of reward to those who own” investment resources. And, he believed in “a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.”!!!

Regulation and non-neutral taxation of the final savers (owners) are the engines of financial innovation because they induce regulatory arbitrage and tax arbitrage. By combining those with lax monetary policy, the process to the present calamity in the financial system is to be understood.

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