Hmmm....where have I heard that before?
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Posted on 11/17/2008 9:43:28 AM PST by bamahead
On Nov. 14, 2008, the Dow Jones Industrial Average closed at 8497.31. On Nov. 13, 1998, the adjusted (for dividends and split) close was 8919.59. There has been great volatility, but no net capital accumulation as measured by the Dow in a decade. Other indexes, such as the Nasdaq, tell a similar story. Capital has been invested but as much value has been destroyed as created.
The U.S. cannot afford to have another lost decade. Or to see the dreams of another generation of Americans who had been told to take responsibility for their financial health by investing in the stock market dashed by failed monetary and fiscal polices.
Today, the most urgent task facing President-elect Barack Obama is stabilizing financial markets by instituting policies that foster economic growth and prevent the type of boom and bust cycle that has just wiped out a decade's worth of wealth accumulation.
Mr. Obama's task is made all the more difficult because there has been a perfect storm of bad policies and practices. Laudable goals, such as fostering more homeownership, went terribly awry. Financial services regulation has failed at its most basic task, protecting the soundness of the system. And a dysfunctional compensation system has given corporate managers incentives to take excessive risks with investors' money.
None of the policies and practices that are now widely criticized suddenly appeared in the past decade. But they were kindling for a financial firestorm that needed only an accelerant and a spark. Both were provided by a policy of easy money that came in response to the bursting of the dot-com bubble in 2000-01, the ensuing recession, and the Sept. 11 attacks.
At first Fed easing was in order. The central bank needed to counter the "irrational exuberance" of the dot-com bubble. And by May of 2000 the Fed had done that by raising the fed-funds target to 6.5%. That needed to come down when the bubble burst. Aggressive cutting brought it to 2% in November 2001.
The problem is the rate remained at 2% or less for three years (for a year it was at 1%). During most of this period, the real (inflation-adjusted) fed-funds rate was negative. People were being paid to borrow and they responded by often borrowing irresponsibly.
Consider subprime mortgages. In 2001, there was $190 billion worth of subprime loan originations -- 8.6% of total mortgage originations. In 2005, there was $625 billion worth of subprime originations -- 20% of the total. In the same period, the percentage of subprime mortgages securitized -- loans that were packaged and sold to investors -- rose from just about 50% to a little more than 81%. (These numbers all trailed off slightly in 2006.) The great easing in monetary policy ended (with a lag) when the Fed began raising rates in June 2004.
The subprime saga follows a familiar pattern. Easy credit begets a boom and then the inevitable tightening of credit bursts the bubble. What is not familiar is the scale of the devastation wrought in this boom-bust cycle.
Never before had financial markets evolved such a complex superstructure of interlinked securities, derivatives of all kinds, and special-purpose investment vehicles. Professor Gary Gorton of the Yale School of Management has best described that complexity in his paper "The Panic of 2007," published by the National Bureau of Economic Research. He makes clear that as this system evolved there was not a sufficient guard against systemic risk.
No president could want these events to repeat themselves on his watch. But they could be repeated.
The economy now confronts deflationary forces. If past is prologue the Fed will concentrate on those deflationary forces for too long and rekindle an asset boom of some kind. The fiscal "stimulus" being contemplated by Congress could be another economic accelerant. If both the fiscal and money stimulus efforts kick in just as market forces also kick in, we're likely to see another unsustainable boom that will be followed by a bust.
The incoming administration must think about that possibility because the timing of boom and bust cycles seems to be shortening. The next bust could come five or six years from now -- or about in the middle of an Obama second term. Should that happen, Mr. Obama would be unable to blame Republicans for the mess and would be tagged as the second coming of Jimmy Charter.
To avoid such a fate, Mr. Obama needs to stop the next asset bubble from being inflated by imposing a commodity standard on the Fed. A commodity standard (such as a gold standard) imposes discipline on a central bank because it forces it to acquire commodity reserves in order to increase the money supply. Today the government can inflate asset bubbles without paying a cost for it because the currency isn't linked to the price of a commodity.
With a commodity standard in place, the government would also have price signals that would alert it to the formation of a bubble. Why? Because the price of the commodity would be continuously traded in spot and futures markets. Excessive easing by the Fed would be signaled by rising prices for the commodity. In recent years, Fed officials have claimed that they cannot know when an asset bubble is developing. With a commodity standard in place, it would be clear to anyone watching spot markets whether a bubble is forming. What's more, if Fed officials ignored price signals, outflows of commodity reserves would force them to act against the bubble.
The point is not to deflate asset bubbles, but to avoid them in the first place. Imposing a commodity standard is a practical response to the repeated failures of central banks to maintain sound money and financial stability. What would be impractical is to believe that the next time central banks will get it right on their own.
So what commodity based economies are more successful than the American economy?
I’m not sure there are any truly commodity based economies left in the world. The International Gold Standard setup after WWII was suspended during the Nixon years, because Nixon needed extra cash to fight the war.
Ever since then, gold has remained virtually disconnected from most every major nation’s currency. And ever since then, we’ve been in a print more as we need it mode, and a consistent state of inflation, which I’m not really sure you could consider a ‘success’...at least not a complete one.
Ask that question in 10 years.
The author picks 1998 as his starting point to poke fingers at his former employer.
One could start earlier. Such as the FED bailing out Long Term Capital Management in 1996.
Another starting point could be the Clinton Treasury Department ceasing to offer 30 year Treasury Bonds.
There are a lot instances of going down the slippery slope since FDR made paper dollars equal to gold.
One thing is for certain “bad money” chases away “good money” and the Central Banks around the world have been stellar performers in the the last 80 years of printing phoney money and creating commodity inflation.
We had a commodity standard in the 1800’s and had deflationary boom bust depression cycles every 20 years.
The Fed has avoided all but one depression since it’s inception.
Tying the Fed’s hands is the worst thing you can do at this time.
So, is the lesson that these cycles are bigger than anything we realize that could could control same?
No, I think the lesson is the opposite. The creation of the Fed, and modern money supply management techniques have been extraordinarily successful in controlling these cycles.
They haven't eliminated them. We still have period recessions, but even those seem to becoming further apart. It will always be an inexact science though.
What has happened is that we have forgotten some of the lessons of history, and in our zeal for globalism, we over-leveraged the banks by repealing Glass-Steagal and lowered the banking reserve ratios. That allowed a confidence crisis to occur that was sparked by the sub-prime mortgages and a money market fund breaking the dollar. And then amplified by the failure of some giant institutions.
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