Tuesday, February 05, 2008

Desmond Lachman's Response

Desmond Lachman has offered a response to my critique of his TCS article. Here is is in full:

Dear Mr. Calhoun,

Thanks for your email.

While we seem to agree on many matters, it seems that we disagree on two basic points. The first is whether or not there is a role for regulation in our market economy. The second, and perhaps more important point of disagreement, is how should the Federal Reserve be responding to today’s bursting of the housing market and credit market bubbles.

I would be the first to highlight the dangers of excessive market regulation and intervention in our economy. However, I would not go so far as you in suggesting that there is no role for regulation in our economy. My view is that there is a need for some minimal regulatory framework within which markets operate in order to prevent the abuses and excesses that would otherwise occur. In this context, it is well to recall that the Federal Reserve was set up in 1913 to prevent a recurrence of severe financial market panics like that of 1907, which were commonplace during the 19th century.

There is no question in my mind that cheap money between 2001 and 2005 was a major contributor to the housing market bubble and to the associated sub-prime lending problem. However, I also think that a major source of the problem was financial innovation outpacing the regulatory framework. In particular, it seems to me that the move to an “originate-to- distribute” model of mortgage finance, coupled with the increased incidence of securitization and the creation of highly opaque and complex credit instruments, have played an important role in today’s banking crisis. In my view, the marked loosening of credit standards could very well have occurred even if monetary policy was not as loose as it was and the Federal Reserve must be held to account for allowing imprudent bank lending to occur on the scale that it did. I would not want to minimize the impact that the estimated US$400 billion losses from mortgage lending will have on the banking systems’ willingness to lend going forward.

On the issue of how the Federal Reserve should be responding to the present situation, I think that it is important to recognize that the US economy is presently being hit by four major shocks that are inter-related to an important degree and that have the potential to throw the US economy into a nasty and prolonged recession. Those shocks include (a) the worst housing market bust since the Great Depression; (b) the most severe credit crunch in the past 25 years; (c) international oil prices at $90 a barrel; and (d) an important correction in equity prices. It would seem that these shocks have already pushed the US economy into recession judging by the latest consumption and employment numbers.

A hands-off approach by the Federal Reserve now runs the real danger of having the US economy slide into a full blown recession that would only aggravate the acute problems that the banks are already experiencing as well as worsening the housing market and credit market busts. That in turn would likely deepen the economic recession. This would seem to be the clear lesson of both the Great Depression and Japan’s lost decade in the1990s following the bursting of its asset price bubble, when the central bank was far too slow in easing monetary policy. It is for this reason that I support the Fed’s belated move last week to a decidedly easier monetary policy stance as well as its commitment to take further measures should the economy weaken further in the months ahead. I would caution, of course, though that the Federal Reserve will need to remove monetary policy ease once the present real recessionary danger has passed.

Best regards,


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