Friday, February 01, 2008

Hello Desmond

Last year on this blog, I spent a few entries debating with Desmond Lachman and it was quite stimulating. Mr. Lachman and I have different views of how the world works but I think we both are gentleman enough to debate in a civil manner. So, Mr. Lachman has a new article at TCS Daily that deserves a response.

The article is titled, "Bernank Also to Blame"; I certainly have no problem with that as I blame most of our problems on the Fed no matter who is in charge.

As the United States' worst housing market bust since the Great Depression raises the specter of a nasty recession, a serious reappraisal of Alan Greenspan's 17-year chairmanship of the Federal Reserve is underway. Justified as this reappraisal might be, it should not be allowed to detract from Ben Bernanke's role in today's US housing market debacle, especially since Mr. Bernanke assumed the Federal Reserve chairmanship in February 2006 a full year before the worst of the sub-prime lending excesses were to be made.

The gist of the article is that Alan Greenspan was responsible for most of our current mess by holding interest rates too low for too long. Furthermore, according to Lachman, Greenspan should have used the Fed's regulatory powers to rein in sub prime lending. As usual, Mr. Lachman prefers a regulatory approach where a free market approach would suffice. Sub prime would never have grown as large as it did if credit wasn't so easily available and the cause of that is the price fixing of the Fed.

Mr. Lachman and I agree on one thing. The Fed ignored asset prices in setting monetary policy and that was a huge mistake. Of course, if the Fed were held to some type of hard money standard this wouldn't be an issue.

Worse still, Mr. Greenspan never tired of arguing that it was not the job of the Federal Reserve to attempt to identify asset price bubbles. Nor did he believe that the Fed should pay attention to asset price inflation in setting monetary policy. He did so in total disregard of the United States' own untoward experience with the bursting of the NASDAQ bubble as well of that of the Japanese experience with the bursting of their asset price bubbles in the late 1980s. Rather, he left it to his successor Mr. Bernanke to deal with the consequences of having created outsized housing price and credit market bubbles.

Mr. Lachman then lays out why Bernanke is also responsible.

While one has to sympathize with Mr. Bernanke's present predicament, which is hardly of his own making, one has to ask why was he as passive as he was in 2006 as the worst of the sub-prime loans were made under his watch. During that year, a total of around US$600 billion in sub-prime mortgage lending, or around one half the total amount of sub-prime lending presently outstanding, was made on conditions that were materially more lax than earlier vintages of sub-prime lending. Indeed, it became commonplace for banks to extend loans up to 100 percent of the value of the underlying property and to make such loans to borrowers without incomes, without jobs, and without assets.

Mr. Bernanke also needs to be held accountable for totally misjudging how serious would be the bursting of the housing market bubble and how large would be the losses to the financial system from imprudent sub-prime lending. In April 2007, when he first identified that something was amiss with sub-prime lending, he assured Congress that the sub-prime problem would be limited in size and that any fallout would be confined to the housing sector. A few months later he was forced to concede that sub-prime mortgage lending might result in losses to the financial system of the order of US$50 billion to US$100 billion, only to have to modify these estimates again to something in the ballpark of US$150 billion. He did so even though current market estimates of sub-prime mortgage lending losses are anywhere between US$200 billion to US$400 billion.

Of course, this is the essential problem with central banking. It relies on a small group of people to set monetary policy for a very complex economy. It can't be done without mistakes being made.

Mr. Lachman also blames Bernanke for not lowering rates fast enough:

Mr. Bernanke's misjudgment of the severity of the housing bust blinded him to the need for early and decisive monetary policy action. Indeed, it was as late as the middle of August 2007 before the Federal Reserve started the current interest rate cutting cycle. This was long after it had become apparent to most market observers that large sub-prime losses and a lack of transparency in the new fangled debt instruments were leading to a seizing up of the international banking system. And even when the Fed did begin cutting interest rates, it did so gingerly and it repeatedly underestimated the downside risks to economic growth from the housing market debacle.

The Federal Reserve's dramatic 75 basis point inter-meeting cut on January 21 suggests that at last the Federal Reserve is grasping how serious is the threat to the economy emanating from a lethal combination of a major housing market bust, an acute credit crunch, and international oil prices at close to US$90 a barrel. While this latest cut is too late to prevent a recession in the first half of 2008, it does give hope that the Federal Reserve will at least not repeat the mistakes of the Great Depression or of Japan's lost decade, when monetary policy was kept too tight for too long in the face of the bursting of large asset price bubbles.

Okay, if the problem was created by a monetary policy that kept interest rates too low for too long, why is the cure to cut interest rates and repeat the cycle? I would also argue that the lesson to be learned from the Depression and Japan is that monetary policy does not work with a broken banking system and that banking sytems are broken by monetary policy that encourages banks to make bad lending decisions. Furthermore, government intervention and Keynesian pumping of aggregate demand merely prolong the pain.

Mr. Lachman wants a world of rules where things are predictable and all problems can be prevented through regulation and other types of government intervention. While that might be a wonderful world, it doesn't exist. Most of our economic problems are caused by government intervention. You can't solve problems created by excessive money creation by creating ever more. Neither can they be prevented through regulation as long as the Federal Reserve is still setting monetary policy based on nothing more than the group guessing of the FOMC.

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