Tuesday, September 04, 2012

What Caused the current Great Recession - and how to get out of it?

A new book has appeared on this subject: Boom and Bust Banking: The Causes and Cures of the Great Recession, published by The Independent Institute, USA.

It is a collection of essays edited by David Beckworth, who is an assistant professor of economics at Western Kentucky University (earlier, he was an international economist at the U.S. Department of the Treasury, before which he was assistant professor of economics at Texas State University).

Lawrence H. White's overview of U.S. monetary policy from the early-to-mid 2000s accuses that of creating the housing boom, because the target federal-funds rate was extremely and unjustifiably low. That influenced even the types of mortgages that came into existence.

David Beckworth argues that the Fed kept monetary conditions so easy for so long because it was concerned that raising the federal-funds rate would jeopardize economic growth. In other words, the Fed was more committed to economic growth than it was to monetary sense.

Diego Espinosa argues that Fed's low interest-rate policy, coupled with the expectation that it would persist, created the new game of borrowing at low short-term interest rates and investing in higher-yielding long-term assets. That is what fuelled securitization, including that of subprime mortgages, and led to the emergence of so-called "structured finance". In other words, the growth of the shadow banking system was the direct and inevitable result of Fed policy.

Christopher Crowe joins Beckworth in arguing that the international housing boom was not caused by a global savings glut, but by the global influence of the Fed: other countries followed similar policies, leading to the flood of global liquidity, and the accumulation of foreign reserves.

In Scott Sumner's view, the recession that started in December 2007 became virulent by the end of 2008 because monetary policy tightened. If the Fed had not been so stupid, it would have understood that it was tightening, and it would have further understood that monetary policy need not be limited by the zero bound. In other words, it could have prevented the Great Recession by real monetary easing.

Jeffrey Rogers Hummel contrasts Ben Bernanke with Milton Friedman. Bernanke believes that financial crises result from aggregate supply problems, so they are best dealt with by having the Fed act as a lender of last resort, which is why, from August 2007 to August 2008, the Fed created liquidity to prop up the financial system, but allowed monetary policy to tighten. On the other hand, Friedman saw financial crises as the result of monetary policy failure. He would have urged the Fed to respond to the sharp decline in monetary velocity in 2007 and 2008.

W. William Woolsey agrees, on the basis that, since any shock to the supply or demand of money disrupts the entire economy, the Fed’s failure to attend to the huge demand for money in 2008, helped transform an economic downturn into the Great Recession. He suggests that the excess money-demand problem also helps explain the liquidity trap, the paradox of thrift, and the balance-sheet recession.

Nicholas Rowe applies Woolsey's explanation to a global level: In 2008, the excess money-demand problem went global because the U.S. dollar is the world’s most important currency. Only one central bank, the Fed, was capable of responding to the spike in the global demand for liquidity. The Fed did in fact supply enough dollars through currency swaps to other major banks, but it was too slow off the mark. Technically (even if not in reality), the Great Recession is over, but the global demand for dollars is still strong, so the Fed must continue to print dollars or face an excess demand that could drive the U.S. economy into recession.

Some of the above may seem like madness for US citizens concerned about a super-inflationary future. So what can be done to avoid the boom-bust cycle growing even bigger (and perhaps even too big) in the future?

Joshua R. Hendrickson calls for the Fed to be bound by a nominal-income targeting rule. Not only is this easier to follow than the Taylor Rule, with which the Fed complies in theory (or when it wants to), Hendrickson believes that nominal-income targeting would make the Fed respond systematically to aggregate demand shocks as well as to ignore aggregate supply shocks. The result would be a stabilization of total current-dollar spending, while changes in the price level driven by aggregate supply would be ignored.

But William R. White wonders whether nominal-income targeting could cause the Fed to ignore other risks, such as credit bubbles which, when they burst, would still need to be bailed out by the Fed. Was it not precisely the Fed’s attempt to clean up after the stock-market decline of the early 2000s that fuelled the housing boom? He therefore thinks the Fed needs to worry not only income and business cycles but also about credit cycles - and it is of course difficult to do everything simultaneously.

Laurence J. Kotlikoff doubts that the Federal Reserve can maintain macroeconomic stability at all. He considers our entire financial system vulnerable, because it is very easy for financial institutions to gamble with other people’s money. Kotlikoff believes in limited-purpose banking: in his ideal world, there will be only two kinds of financial mutuals: one providing investment opportunities, the other providing checking accounts 100-percent backed by highly liquid assets. This is not very far from the Glass-Steagall Act, with the additional consideration that the Fed would then gain complete control over the money supply and so be better able to stabilize aggregate demand.

George Selgin explores how monetary conditions might evolve in the absence of central banks: private banks would issue banknotes fractionally backed by some kind of reserve, and those banknotes would circulate as cheques do today. They would be cleared as banks return their competitors’ banknotes directly to them for redemption or through a central clearinghouse; any dues owed by one bank to another would be netted or settled by transferring reserves.

There is a lot to discuss in this book but (apart from my asides above) let me for the moment confine myself to the following observation: Assuming Selgin does not believe in conspiracy theories, why did Selgin's solution (unregulated banking with competitive issuing of notes) fail in actual history to provide that stability and lead instead to the formation of the Fed in the first place?
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