18 October 2009

Misguided Monetary Mentalities ~ Nolan

Nobel Prize economist Paul Krugman – of Princeton and the New York Times – wrote a noteworthy piece this week: Misguided Monetary Mentalities (NYT 10/12/09).

“One lesson from the Great Depression is that you should never underestimate the destructive power of bad ideas. And some of the bad ideas that helped cause the Depression have, alas, proved all too durable: in modified form, they continue to influence economic debate today.

What ideas am I talking about? The economic historian Peter Temin has argued that a key cause of the Depression was what he calls the ‘gold-standard mentality’ By this he means not just belief in the sacred importance of maintaining the gold value of one’s currency, but a set of associated attitudes: obsessive fear of inflation even in the face of deflation; opposition to easy credit, even when the economy desperately needs it, on the grounds that it would be somehow corrupting; assertions that even if the government can create jobs it shouldn’t, because this would only be an ‘artificial’ recovery.

In the early 1930s this mentality led governments to raise interest rates and slash spending, despite mass unemployment, in an attempt to defend their gold reserves. And even when countries went off gold, the prevailing mentality made them reluctant to cut rates and create jobs. But we’re past all that now. Or are we? America isn’t about to go back on the gold standard. But a modern version of the gold standard mentality is nonetheless exerting a growing influence on our economic discourse. And this new version of a bad old idea could undermine our chances for full recovery.”

First of all, Dr. Krugman states that “the bad ideas that helped cause the Depression… continue to influence economic debate today.” Well, let’s say they were actually “bad ideas.” Even then his implication would be only somewhat true. There may be some feeble little impact on what has regressed to one lopsided “debate.” But, regrettably, ideas regarding sound money and Credit long ago lost their influence on actual economic policymaking.

Dr. Krugman, like so many economists of our time, is an inflationist. He, like so many before him, sees easy Credit and the government printing press as the solution to unemployment and other economic problems. And - in our age of electronic “money” and unbounded global finance - there are apparently no longer any bounds to U.S. fiscal and monetary stimulus.

Messrs. Greenspan and Bernanke are inflationists. The inflationists have been running the show since easy Credit was employed to juice the system after the 1987 stock market crash. The consequences of that bout of policy-induced excess led to a more potent inflationist policymaking elixir in the early-nineties to mop up the financial mess. Since then, ever more emboldened Credit inflation has been required to battle crisis after crisis after crisis. Easy money and Credit – the bane of Capitalism – were allowed to overwhelm the workings of the system. The point of Trillion dollar deficits and zero interest rates has been reached – with the undeterred inflationists now bent on this sorry state of affairs continuing indefinitely.

By now, one would hope the inflationists would challenge their own views, doctrines and Mentalities. Instead, they trumpet the same old failed policy responses – only in much larger dimensions and with greater conviction. And that is precisely the flaw in inflationist doctrine: once it gets rolling it becomes extremely painful to rein in the forces pushing for only greater inflation. The more spectacular the inflationary boom and bust - the more strident the inflationists become.

History is strewn with enough collapses, worthless currencies and social upheaval that I find it ridiculous that the inflationists would today be taking shots at sound money and Credit. It is the inflationists Clinging to Misguided Monetary Mentalities. The principle of sound money and Credit has no reason to have to defend itself.

Inflationism doctrine is riddled with failings: Easy Credit distorts system pricing mechanisms; foments destabilizing speculation; spurs societal wealth transfer; distorts the underlying economic structure; fosters financial fragility; and debases the currency – to name just a few. History – including recent history – validates this analysis.

Yet there are two particular facets of today’s inflationism that make “Keynesian” policymaking extraordinarily dangerous. First, the global backdrop is one of unchecked Credit and the absence of any disciplining global monetary regime. Policy mistakes are free to run longer and with enormous global financial and economic consequences. Second, policymakers and pundits herald incredible post-Bubble policy responses, while failing to recognize that aggressive stimulus is, once again, fostering problematic Bubbles. For too long the inflationists have been negligent in their disregard for Bubble dynamics.

From Dr. Krugman: “Consider first the current uproar over the declining international value of the dollar. The truth is that the falling dollar is good news. For one thing, it’s mainly the result of rising confidence…”

While confidence in the global reflationary backdrop may be rising, the dollar is in trouble. And many dollar apologists will claim the greenback has no immediate replacement and thus will retain its status as the world’s reserve currency. This line of reasoning misses the key point: the dollar reserve global monetary “regime” has broken down as a mechanism for supporting stable global Credit and economic performance. Unchecked global finance now rules, a consequence of the massive and ongoing devaluation of the world’s reserve currency.

Only the inflationists could argue the dollar’s current predicament is “good news.” I don’t see it. I don’t view a world economy rebalancing or becoming more stable. Instead, we’re witnessing the unleashing of another furious global boom and bust cycle. Crude oil traded above $78 this week as gold responded to the weak dollar by surging to an all-time record high. U.S. wealth is being shifted overseas, and Americans’ savings are being devalued. We are losing financial power by the day. Good news? More easy Credit to the rescue?

The inflationists are keen to argue that, with “inflation” remaining so low, policymakers enjoy unusual latitude to stimulate. By this point, haven’t we learned that rising CPI is not a primary contemporary risk associated with ultra-loose monetary policy? The mispricing of risk, unchecked speculation, asset-Bubbles, financial fragility, and economic maladjustment have already proven themselves as deleterious effects of loose money. I group these types of responses to unstable finance (“money and Credit”) as “Monetary Disorder.” Anyone watching global markets these days must recognize that Monetary Disorder remains powerfully entrenched.

Krugman Concludes: “We do seem to have avoided a second Great Depression. But giving in to a modern version of our grandfathers’ prejudices would be a very good way to ensure the next worst thing: a prolonged era of sluggish growth and very high unemployment.”

The first Great Depression was triggered by financial collapse – a historic boom and bust. The jury is still out on the second. The inflationists believe their policy prescriptions strengthen system underpinnings. I believe another bout of global Credit and speculative excess increases the likelihood of eventual financial meltdown. And I believe a dollar crash significantly increases the risk of a very problematic U.S. financial crisis. Worse than benign neglect won’t suffice. Dr. Krugman doesn’t think it makes any sense to consider raising rates. I don’t think it makes any sense to disregard the reality that fiscal and monetary policy went to dangerous extremes.

The time has come for a more level-headed and even-handed approach. As much as they abhor the notion of sound money and Credit, the inflationists need to back away from their dogma before it’s definitely too late. A prolonged period of slow growth and sluggish employment is not the worst-case scenario.


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