Punk, Ziegel analyst Richard X. Bove argues here that recent Fed policies and pronouncement amount to a bailout of Countrywide Financial. If so, then Bernanke’s Fed is similar to Greenspan’s in that the latter also directed Fed policy to help Long Term Capital Management.
Bove: The Fed protected “moneyed interests and bad business policies” and “may have certified rather than prevented a recession. By allowing bad investment to remain in force, the Fed prevents the freeing up of money for good investments.”
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Fed priorities in reverse order:
3. maintain price stability
2. maintain full employment
1. Ruin those who don’t believe (ie “Bears”) in the almighty Fed (ie the Ivy League cabal)
Just finished reading Paul Krugman’s “The Return of Depression Economics”. It is a disgrace.
Bove’s analysis is rather shallow.
Granted the current problems with the loan market have been in large part been created by the FED with help from its co-conspirator, congress, but the recent actions by the FED to lower the Discount Rate was the right initial move.
The current crisis was in large part caused by the FED allowing interest rates to approach their normal level of 3-4% (this was normal during the years of the gold standard), but the FED increased interest rates following their Don Quixote interest rate policies as they fought a non-existent inflaton.
But we must be realistic. We must deal with the economy as it is right now after all of the destructive actions of the FED and Congress. If you tell your child not to go near the water but your child disobeys and fall in will you simply let him drown to make your point? This is exactly what Bove is recommending.
The problem is a long term problem but if we do not deal with the short term we could be facing a worldwide problem greater than any of us want.
Well how ought one deal with the problem? Shouldn’t market forces be allowed to reassert themselves?
Anthony,
Of course we should let the market rule, but the FED screwed things up and we can’t just let everything sink.
My prescription is that the FED begin to lower interest rates until they reach 0. Then they should announce that they will use the FOMC to maintain the market dollar POG at a specific price, perhaps $650. This would immediately stabilize money and end any inflation or deflation. Then, since I am playing Santa Clause, Congress should prepare a budget for only essentially services then taxes should be cut to only fund those projects. I just had to introduce a little fantasy.
DickF:”The current crisis was in large part caused by the FED allowing interest rates to approach their normal level of 3-4% (this was normal during the years of the gold standard)…”
Interesting analysis, but why would the interest rate set during the gold standard era, decades ago, be appropriate for today? People today a much less concerned about saving for the future. Under the gold standard, we didn’t have social security or all of the other welfare programs that discourage savings. I’m thinking interest rates should be closer to 8%.
DickF: “We must deal with the economy as it is right now after all of the destructive actions of the FED and Congress. If you tell your child not to go near the water but your child disobeys and fall in will you simply let him drown to make your point? This is exactly what Bove is recommending.”
If not lowering interest rates would cause someone to die, I would be all for the Fed lowering interest rates as much as possible. But no one will die. They will just lose some money. Bailing children out every time they make a bad decision causes them to lose respect for cause and effect and encourages more irresponsible behavior. The same is true of adults who make poor financial decisions. Suffering for one’s bad decisions is what civilizes mankind.
You may be thinking that deflation is a serious problem because mainstream econ teaches that deflation caused the Great Depression. But it deflation wasn’t the cause; it was an effect of business failures and loss of confidence in paper money. The business failures resulted from the poor investment decisions by businessmen because of the Fed’s low interest rate policies of the 1920′s. People lost confidence in paper money and banks because so many banks failed as a result of their being overextended, also a result of the Fed’s policies.
DickF: “My prescription is that the FED begin to lower interest rates until they reach 0. Then they should announce that they will use the FOMC to maintain the market dollar POG at a specific price, perhaps $650.”
Lowering interest rates to zero and maintaining a peg to gold contradict each other. Lower interest rates would expand the money supply dramatically, causing the value of the dollar to fall and the price of gold to rise.
Austrians prescribe doing nothing because the malinvestments made during the boom must work themselves out in order for the economy to return to healthy growth. Lowering interest rates only encourages more bad decisions by businessmen. Japan is a great example. The Japanese central bank followed your advice in the late 1980′s when their bubble burst. They lowered interest rates to almost zero. As a result, it took 10 years for the economy to recover. Had they let businesses go bankrupt as Austrian prescribe, their recession would have been much shorter.
“Banking regulators urged lenders to restructure the loans of millions of borrowers at risk of losing homes. The credit crisis pushed up the London interbank offered rate, which may have an impact on markets and the economy.”
The foregoing is from an article in today’s WSJ. Of course, there is no reason to think that regulated lenders would alter their behavior to accomodate their regulators.
And, the following is from the WSJ of 8/31.
“Mr. Bush, meanwhile, promised that he would work to assist homeowners now struggling to keep up with their monthly mortgage payments. He urged changes in the tax code, called for rigorous enforcement of predatory-lending laws and called for changes in the Federal Housing Administration mortgage-insurance program to let more people refinance with FHA insurance if they fall behind on adjustable-rate loans.”
It seems to me that we now have the successor to the Greenspan put: the B(ernanke) and B(ush) put.
RogerM,
You have given me a lot to respond to.
When Greenspan lowered interest rates to 1% he also maintained a relatively consistent value of the currency relative to the POG, there was no inflation nor deflation, and commercial rates went to 3-4%. If you are a student of history you will recognize that this is the rate for most of the history under the gold standard. To say that interest rates would be 8% is to buy into Keynesian inflationism. Granted under current FED policies 8% might be the market rate, but it is an unnatural rate caused by FED monetary policy.
Social Security is a tax and welfare spending program. 401K activity is savings. Government spending does not force rates higher or lower. Rates are high because of inflation. Returning to a sound currency will return interest rates to a more reasonable rate.
Granted my example of a child falling into the water was absurd to the extreme but that was to illustrate the point. There will always be pains that must be endured when an economy returns to equilibrium after a boom, but the impact of the economic dislocations can be minimized if the conditions that caused the boom are dealt with prior to the bust. Forcing the victims of bad government policy into economic distress, especially when they don’t understand, is like disciplining a dog the day after he messes on the floor. He has no idea why you are making him suffer. It is foolish to cause economic distress just to prove a point if the ill results of the recovery can be minimized. I do not believe that economics is the dismal science. Economics should be the science of prosperity.
No, I do not believe that the Great Depression was caused by deflation, but neither do I see any evidence that it was due to a loss of confidence in paper money. Since this line of reasoning is invalid I will not comment additionally other than to say that your position that the FED caused the Great Depression actually implies that the gold standard does not work. I believe that the gold standard does work.
Your statement that lowering interest rates to zero and maintaining a gold peg contradict each other implies that you buy into the FED interest rate regime. My point about the FED lowering the FFR to zero means that the interest rate should return to a market rate. The interest rate is a horrible method off controlling the supply of money relative to demand. If the FED follows a system of targeting the POG and using its open market power to buy and sell bonds to maintain the value of money supply indicated by the POG the interest rate will take care of itself based on market demand.
I do not believe that Mises would prescribe doing nothing. He would call for a return to a gold regime and stable money pegged as close to the current market POG as possible.
For 10 years Japan followed a deflationary policy which can be easily seen if you look at the yen POG over the period. Had the BoJ reacted to the deflation by increasing the money supply to maintain the yen POG, Japan would have had no deflation. Understand that this is to say that the BoJ should not increase the money supply to generate inflation but to maintain the value of the yen relative to gold, preventing deflation. If the yen POG climbed above their target rate they would sell bonds to reduce the money supply to strengthen the yen returning it to the target rate yen POG. Had the BoJ done this they would not have suffered deflation.
DickF: “When Greenspan lowered interest rates to 1% he also maintained a relatively consistent value of the currency relative to the POG, there was no inflation nor deflation, and commercial rates went to 3-4%.”
During the 90′s, prince inflation averaged around 3% as measured by the indexes. But monetary inflation must have been much higher because of the surge in productivity. With productivity increases at about 2.5% annually, monetary growth would have had to equal at least 5.5% for price inflation to rise 3%. But we also had price inflation in the asset markets, especially stocks. So monetary inflation probably averaged closer to 10%.
So why didn’t gold prices rise as well? Visit the World Gold Council web site and you find that gold is a great long term hedge against inflation, but a poor short term hedge, even under 10 years. The prime determinant of the price of gold is the demand for it in India and China, whose people still view it as money. So just because gold didn’t respond to Fed monetary inflation, and price inflation, during the 90′s doesn’t mean there wasn’t any inflation.
“Granted under current FED policies 8% might be the market rate, but it is an unnatural rate caused by FED monetary policy.”
Actually I was speaking of short term rates. They should be 8%, which would make 10-yr rates closer to 10%. Austrians believe that the time preference of investors determines the natural rate of interest. Another way to put it is to say that people’s preference for present comsumption versus future consumption determines interest rates. The Fed can manipulate only nominal interest rates, or market rates. Monetary inflation, and the resulting price inflation, result when the Fed keeps market rates below natural rates, which it has done since its founding. The natural rate of interest today should be quite a bit higher than the natural rate under the gold standard, because people under the gold standard were forced to save for housing, retirement, sickness, and other problems for which no one would bail them out. Since WWII, the willingness of Americans to save has declined dramatically with the many government programs that bail people out if they don’t save.
“…but the impact of the economic dislocations can be minimized if the conditions that caused the boom are dealt with prior to the bust.”
The condition that causes the bust is the excessive growth in the money supply that lowers interest rates below the natural rate. If the Fed would stop force feeding the economy money, the boom would not bust. The Fed is doing nothing but shutting the barn door after the horses have left. It can’t prevent a bust in the housing market; that has already happened.
You believe that Fed easing of interest rates will fix what went wrong in the housing market. But it’s the Fed’s continual easing of monetary policy at the sign of any discomfort that causes the problem. All Austrian economists recommend that the Fed do nothing when the bubbles it has blown burst, because only if the Fed does nothing can the market clean up the mess the Fed has caused. All Austrian economists warn that if the Fed lowers interest rates to prevent disaster, the situation will grow worse and stay bad longer.
“…but neither do I see any evidence that it was due to a loss of confidence in paper money. Since this line of reasoning is invalid I will not comment additionally other than to say that your position that the FED caused the Great Depression actually implies that the gold standard does not work. I believe that the gold standard does work.”
Actually, I wrote that loss of confidence in paper money contributed to deflation, not to the depression. Mainstream economists, including Mr. Bernanke, blaim deflation for the Great Depression. If you’ll read Rothbard’s awsome history of the Great Depression, you’ll understand that we were not on a true gold standard after the creation of the Federal Reserve. That’s why the Fed could inflate the money supply to such an enormous degree during the 1920′s.
“My point about the FED lowering the FFR to zero means that the interest rate should return to a market rate.”
I don’t understand you here. The Fed rate is the market rate for short term interest rates. And it strongly influences long term rates. If the Fed set it’s rate at zero, banks could borrow money from the Fed at zero interest. That would give them enormous incentive to borrow all they could and loan it out. But to loan out that much money, they would have to lower their rates to 2-3%. At such low interest rates, people would borrow money and expand the money supply.
You suggest that the Fed soak up that excess money buy selling short term notes and bonds. The purpose of selling into the market is to soak up excess money. In order to sell bonds, it would have to offer a higher interest rate than that of the banks. People could get rich borrowing from banks and selling to the Fed. It doesn’t make much sense. If the Fed sold bonds to soak up the excess money, long term interest rates would rise and you would stand the term structure on its head with short term rates at 0 and long term at say 12%. There would be a mad rush to borrow short term and invest for the long term.
“I do not believe that Mises would prescribe doing nothing.”
Well, he did. Many times, beginning with the German hyperinflation of the 1920′s, he told central banks to do nothing and let the market clean up the mess the central bank had caused. Yes, he advocated a return to gold, but a true gold standard, not the scam that existed between the wars.
“For 10 years Japan followed a deflationary policy which can be easily seen if you look at the yen POG over the period.”
As I wrote above, gold doesn’t track short-term inflation well, so it’s not a good measure of price inflation. But deflation wasn’t a problem for Japan; it was a blessing because it increased the purchasing power of the yen and made people who saved richer. Japan’s problem in the 90′s was lack of growth, and the central bank caused a decade of stagnation because it refused to let bankrupt businesses go bankrupt by continuing to loan them money at almost zero interest rates. Had Japan followed Mises/Hayek instead of Keynes, there economic bust might have lasted a couple of years instead of 10.
Thanks for your comments DickF and RogerM.
Roger,
I am a Misian and you are a Rothbardian and so we will see things differently. You probably do not see a difference between the two, but the difference is profound, especially as it relates to monetary policy and the gold standard.
Your method of determining inflation is rife with unsupported assumptions: “monetary inflation must have been much higher because…â€, “would have had to equal at least…â€, “monetary inflation probably averaged…†You don’t need to do this. If you look at the historical POG you will see that it tracks monetary conditions much better than any econometric model or analysis. POG contains both the impacts of supply and demand.
Monetarism only considers supply, Keynesianism only considers consumer goods demand (though Keynes himself believed in the gold standard), and then there are other econometric models that spend pages and pages of analysis simply trying to define money. As Mises understood gold is all you need.
You mention The World Gold Council but you need to recognize that it is in the business of selling gold as a hedge against inflation. There is nothing wrong with this, but gold is not a good investment during a deflation.
Gold holds you in one place monetarily. In a time of inflation gold holds its value as the currency declines in value, but in a time of deflation gold also holds its value as the value of the currency becomes stronger.
The prime determinant of the POG is not demand for gold. What you have to understand is that it is not gold that changes when the POG changes, but money substitutes. The demand for gold and the supply for gold remain virtually unchanged, but monetary authorities increase or decrease the supply of money substitutes at the flip of a switch. It is changes in the supply of money substitutes that are the prime determinants of changes in the POG.
Now this is what makes gold the best measure of money value and the best indicator of inflation/deflation. And because gold is the most monetary of commodities it also is the earliest indicator of inflation/deflation.
Concerning interest rates Mises believed that the originary rate of interest is determined by time preference but as he states in Human Action: “Originary interest can therefore in the changing economy never appear in a pure unalloyed form. It is only in the imaginary construction of the evenly rotating economy that the mere passing of time matures originary interest…†Then he continues in a later chapter: “The market rates of interest on loans are not pure interest rates.â€
One of the mistakes that the FED makes is that it confuses the market rate of interest with the natural rate of interest. When you write: “The natural rate of interest today should be quite a bit higher than the natural rate under the gold standard†it appears you are doing the same.
As Mises states the originary rate of interest exists in the imaginary construct of the evenly rotating economy. The market interest rates we are seeing today are filled with what Mises recognizes as “components contributing to their determination there are also elements which are not interest.â€
You may also have a misunderstanding of savings. Savings is closely related to the demand for money. If we are in an inflationary period there will be a reduced demand for money and an increased demand for hard goods to store value. A weak currency will not be saved and demand will be reduced, money savings will be reduced as hard goods “savings†increases. Government statistics do not recognize hard goods savings as savings.
The boom is created by excessive inflation not the bust. The bust comes when the malinvestment can no longer be sustained. To borrow from Roger Garrison, Ivan can no longer build houses.
Of course the FED can do nothing about that part of the bust that has already happened, but that does not mean that they cannot prevent a continuation of the bust or a more severe bust. Let me give an example. If after the Civil War the monetary authorities had revalued the dollar at the proper level relative to gold there would not have been a huge deflationary recession brought on by the correction. If you have questions about this revaluation when returning to a gold standard see Mises, “Theory of Money and Credit.â€
No, I do not believe that FED easing of interest rates will fix what went wrong, but FED manipulation of interest rates has taken the economy on a roller coaster ride of inflation/deflation that is totally unnecessary. You cannot accurately maintain a stable value of money using interest rates.
Not all Austrians economists recommend that the FED do nothing. Some actually understand Mises on monetary policy. Dig deeper into why Austrians oppose a reduction in interest rates below the natural interest rate. Also dig deeper into when and why the monetary authorities should do nothing. If you believe monetary policy should be punitive then you do not understand monetary policy.
You did write, “…loss of confidence in paper money contributed to deflation…†but you have it backward. A loss of confidence contributes to inflation because of a reduced demand for holding currency. Deflation increases the demand for money because it is increasing value.
I have read Rothbard’s “America’s Great Depression†it is one of my best resources, but Rothbard does not understand his own findings. Rothbard does not really understand the gold standard and so his analysis is flawed. He promotes in a system of gold money that has actually never existed in history, not a gold standard. You will need to give me evidence of FED inflation in the 1920s. Just for the record Rothbard asserts it but never gives evidence.
You do not understand my statement about the FED taking the FFR to zero because you are attempting to work within the existing FED methodology and I am saying they must change their interest rate method. The FED should only lend money in its role as lender of last resort. It should stop attempting to use the FFR and its interest rate targets to manipulate the currency for political reasons.
If we were on a system where the interest rate was actually set by the market, interest rates would become very stable around the 3-5% range. It would be a simple matter for the FED to buy or sell bonds to maintain the value of money in terms of POG. And do not forget that if it is known that the FED will target the POG the market will often arbitrage the POG to the FED target. If the POG increases gold investors will sell knowing that the FED will bring the POG down. If the POG falls gold investors will buy.
Mises did not prescribe doing nothing in the 1920s. As a matter of fact he took the monetary authorities out into the street in front of the printing office and told them to stop the presses and stabilize the currency to the current market POG. But understand that Mises did not advocate only gold money.
Your statement, “But deflation wasn’t a problem for Japan; it was a blessing because it increased the purchasing power of the yen and made people who saved richer†demonstrates a serious misunderstanding of deflation. In a sense you are subscribing to Bastiat’s broken window fallacy. There are some who can get richer in deflation, but they do it at the expense of others, just as there are those who can get rich in inflation at the expense of others. Monetary errors causing either inflation of deflation always destroy wealth. Deflation causes those who entered into contracts during the previous period to pay back with more expensive dollars. For a business this can be a disaster because their income declines due to deflation, but their expenses contracted in previously valued yen will not.
You do hit on one thing about Japan’s problem. The perfect solution would have been a tax cut growth centered economy with a stable currency, the same policies they followed in the 1950s and 60s. The stagnation of growth was not because bankrupt businesses were saved and interest rates were lowered. Japan had a stagnation of growth because they increased taxes every year for over 10 years in an attempt to counter the effects of lower tax revenue due to deflation.
You are correct that if Japan had followed Mises, Hayek and – may I add – Bob Mundell they would have had no 10 year deflation.
DickF, I surrender. One of us is very confused.
Thanks Roger. I accept your surrender and will pray for resolution of your confusion.
Thinking about my discussion with Roger I realized that some may not understand the methodology the FED uses in an attempt to stabilize the currency, so for anyone who makes it this far down in the posts let me add the following.
The FED has two rates that they control. One is the Discount Rate, the rate they just reduced, that is the rate at which they loan money. This rate is usually higher than market rates so there is normally not much borrowing from the FED.
The second rate is the Fed Funds Rate(FFR). This is the primary rate that the FED uses. The FFR is the rate on money that banks borrow from other banks to maintain their reserve requirements. The actual rate could be from .05% or 8% or lower or higher depending on the availability of funds and the demand for funds. Why would a bank loan at .05%? This is an overnight rate and any interest is better than idle money.
Now what is important about the FFR rate is that it is not a direct setting of a rate but is a target. The FED establishes a target and then they use their open market transactions to adjust the money supply to bring the average rate to their target. If you follow that you will understand how cumbersome it is and how it can be rife with error. The very actions of establishing the funds rate invites all kinds of problems that are recognized by Austrians. I will not go into that.
Let me close by saying my suggestion is much cleaner and much more direct than the messy system the FED currently uses. The FED should use the price of gold as their target, rather than a loose questionable interest rate filled with all kinds of components that are not monetary. Then they should use their open market transactions to directly change the money supply to hit this target POG buy buying or selling bonds to either increase the money supply or reduce the money supply. This would be simple, easier, more direct, and more precise.
DickF:”The FED should use the price of gold as their target…”
In his early days, Greenspan mentioned gold and other commodities often as prices that he used as guides to monetary policy. But the price of gold remained relative flat throughout the 90′s, which gave Greenspan an excuse to flood the country in new money. Gold was slow to respond to his monetary pumping, so Greenspan kept it until, producing the stock market bubble and crash, just as he and Bernanke caused the housing bubble/crash.
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