Financial Times: Depression is Possible If Central Banks Don't Force a Recession

That's my interpretation of this thought provoking and well written article.

Recession is not the worst possible outcome

By Wolfgang Münchau

Published: July 6 2008 17:53 | Last updated: July 6 2008 17:53

http://www.ft.com/cms/s/0/8362b1d0-4b59-11dd-a490-000077b07658.html?nclick_check=1

If this had been a mere financial crisis, it would be over by now. The fact that we are suffering its fourth wave tells us there might be something at work other than merely financial euphoria and bad regulation. Maybe this is not a Minsky moment after all. Hyman Minsky, the 20th century US economist, formulated the long forgotten, and recently rediscovered, financial instability hypothesis, according to which capitalist economies, after a long period of prosperity, end up in a vicious circle of financial speculation. The Minsky moment is the point when what economists call this “Ponzi game” collapses.

But there might be better explanations. As the Bank of International Settlements said in its latest annual report, subprime might have been the trigger for this crisis, but not the cause. We do not have a full understanding yet of what happened but the BIS suggested that fast expansion of money and credit must have played a role. I would go further and say this is not primarily a crisis of financial speculation, but one of economic policy. Its principal villains are therefore not bankers, but economists – not in their role as teachers and researchers, but as policy advisers and policymakers.

So who are they? I recall a wonderful episode told by Jagdish Bhagwati in his book In Defense of Globalization when he quoted John Kenneth Galbraith as saying: “Milton’s [Friedman’s] misfortune is that his policies have been tried.” In fact, this is not the worst that could happen. The worst is for economists to try out their own theories themselves. This happened to several highly respected academics who have since become central bankers or finance ministers. If, or rather when, they turn out to be wrong, they risk a double reputational blow – as policymakers and as academics. So do not count on them to change their mind when the facts change.

Several of them have been leading proponents of an economic theory known as New Keynesianism. It is, in fact, probably the most influential macroeconomic theory of our time. At the heart of the New Keynesian doctrine stands the so-called dynamic stochastic general equilibrium model, nowadays the main analytical tool of central banks all over the world. In this model, money and credit play no direct role. Nor does a financial market. The model’s technical features ensure that financial markets have no economic consequences in the long run.

This model has significant policy implications. One of them is that central banks can safely ignore monetary aggregates and credit. They should also ignore asset prices and deal only with the economic consequences of an asset price bust. They should also ignore headline inflation. An important aspect of these models is the concept of staggered prices – which says that most goods prices do not adjust continuously but at discrete intervals. This idea lies at the heart of some central bankers’ focus on core inflation – an inflation index that excludes volatile items such as food and oil. There is now a lively debate – to put it mildly – about whether an economic model in denial of a financial market can still be useful in the 21st century.

So when economists tell us that we need to keep real interest rates negative, just as we did for long periods in the past 15 years, or that we now need to bail out homeowners and banks and raise our national debt in the process, or ignore any considerations of moral hazard while the crisis is raging, we might want to question whether the recipes that got us into this mess are also most suited to get us out again.

If we believe, as the BIS does, that a rapid expansion of money and credit has either caused, or significantly contributed to, the build-up of asset price bubbles and higher inflation, the opposite policy conclusions might be more appropriate.

Under this setting, the priority might be not to impede the fall in asset prices. Real house prices in the US, the UK and several other economies might end up falling by some 40-50 per cent, peak-to-trough, in the downward phase of this cycle. Let this happen and do not implement policies to prevent this fall – such policies might alleviate some pain in the short run for some people but will make the adjustment last a lot longer.

Second, monetary policy should be geared towards price stability first and foremost. When inflation expectations rise, real interest rates should be positive. This would necessitate a large interest rate increase in the US and further interest rate increases in the eurozone as well.

Third, allow some defaulting banks to go bust.

Fourth, implement long-term policies designed to reduce volatility. Among these are: a change in the monetary policy framework to take explicit account of asset price developments; the removal of pro-cyclical incentives in the banking sector; stricter regulation of mortgages, such as the encouragement of fixed-rate loans and the imposition of maximum loan-to-value ratios; more exchange-rate flexibility in countries with fixed or semi-fixed exchange rates and, of course, the development of alternative energies to reduce our reliance on oil.

We might run a greater risk of a recession in the short term. But a recession is not the worst possible outcome. The worst is for this crisis to go on and on, for Minsky’s moment to become an eternity.

 

Thanks for posting that, ByLo.

FT is one of the last credible ECON journals left.

Yet, its always telling when economic authorities and Central Bankers are quoted as aghast and dumbfounded by the Credit Crisis. And that *maybe* loose credit had *something* to do with it.

"Maybe"?!? "Something"?!?!

Don't believe it for a second.

This is not rocket science. Injecting dollars bills into a fixed economy with no commensurate expansion in production equals one thing = inflation.

They all know it, too (this is 101-type stuff). Just like they knew it in 1929. Yet, the Depression happened anyway... Thats an interesting little aside School Master Bernacke never addressed. Gee, wonder why?! Rothschilds knew all about credit supply and economic cycles some 300 years ago...

The articles conclusion is correct. Zimbabwe is a contemporary example of economic Warfare against a People. Most private savings were wiped out. Or, IOW, stolen by Government.

America is a bigger ship, but she'll sink just as assuredly as a leaky dingy like Zimbabwe. Just take longer to bring her down.

Its all about discretionary income. If printing continues, commodities and energy will continue to rise. Americans will spend more and more for food and gas. Consumables will pass on factor input costs. Now its food, gas and everything at Walmart thats more expensive. People buy less while spending more and the economy collapses on itself.

Wage-price spiral will be the next fundamental event to the hit newswire. We'll see it in 2008, for sure.

It could go 1970's-ish stagflation before it goes deep recession or depression.

If the money print continues unabated for the next few years (God Forbid), then yes, it will be a depression. Wages never keep pace with real inflation. People will spend nearly everything they make just to live. The economy will go bye bye for a real long time.

 

thanks for finding interesting articles...

sell sell selll....and sell.............

 

i am not sure where FT took that money and inflation does not matter in new keynesianism. it is both central to this theory, e.g consider Taylor rule and IS/LM framework (with sticky prices).

the important point is valid though - without cold shower this patient is not going to wake up... by the way I really think that as soon as fed starts hiking the market is going to launch like a rocket.

 

I don't understand why recession has become a dirty word. It's always been a part of the economic cycle, but it seems like in our I want it now and I never want any setbacks new world we have forgotten anything like that.

 

Yeap. But prices tend to 'unstick' abruptedly. Business are loathe to raise prices in a slow economy out of competitive fear.

But once input costs get too high and margins anemic, a few larger chains will raise. Then the herd jumps on the bandwagon. Because everyone else is doing it...

 

Why do you think that?

I'm genuinely curious.

 

the fact that fed is raising will be interpreted that the worst of the credit crunch is over. it should start up lots of capital intensive projects as people try to catch cheap rates (of course this time only if they have a good credit). equity markets will see this.

also remember greenspan's last set of hikes?

all this is assuming that they start to raise early (e.g. after summer holiday in Sep08) and do not wait till US economy is wasted by inflation.

of course i may be wrong - but at least i'am putting money where my mouth is.

 

It won't be interpreted as worst is over. But it might be interpreted as Fed still has some shame and decided to slow down money printing which will in turn pressure commodities pricing

i guess skyrocketing commodities take more than low rates give

Anyway it was already proved many times - low rates below inflation make things worse

 

you're right. worst is by far not over - but the worst of credit crunch should be.

the biggest problems of all is USD and what to do with it - literally.

p.s. glad to see (after a year) somebody familiar who was not a total dick . by looking around it looks like ET did not get much better since.
cheers