Money Sage (archive)

It is interesting to note the rising chorus of criticism of the FED's dramatic policy change. This places us in the unfamiliar position of having to defend our not-so-illustrious central bank.

The criticsm, which originates from the dierhard inflation-phobes, is now spreading rapidly to the keepers of the flame of monetary orthodoxy. These include important voices in the financial, economics, and media establishment. The party line is that the FED's big rate cut, and, horrors, the prospect of further rate cuts, raise the specter of INFLATION. Nor is this all. According to the inflation-phobic camp, we are entering a period of stagflation, similar to the 1970s. This land of horrors was characterized by a wretched economy, rampaging inflation, and a FED which, until the advent of Paul Volcker, could not print up currency fast enough. The FED "accomodated," then "monetized" the inflation, with support from the supposedly conservative Republican Administration in Washington.

Bernanke's former supporters -- those who heretofore endorsed the Chairman's foot-dragging in the face of a deepening distress in the banking system and an evolving credit contraction, with ominous implications for the economy -- have now become his sternest critics. What is needed is not relief, but MORE CASTOR OIL FOR THE SICK, VOMITING PATIENT, ie. the economy. In addition to those who are genuinely motivated by an hysterical fear of inflation, and who fail to see that the analogy with the 1970s is a FALSE ONE, there are those who embrace the theological imperative of financial Calvinism: the sinner must pay for his sins! Who is the sinner, and what are his sins? The sinner the financial Calvinists have in mind, we think, is the ordinary Joe. The ordinary guy has borrowed too much, consumed too much, lived too high on the hog. Now he must get his comeuppance.

Lurking beneath this, we believe, is a sense of upper class outrage. How dare these peons seek to rise above their station! This is an intolerable affront to the nouveaux riche and their journalistic, economist, and banking minions. These people need to be put in their place! As for certain chronic seers of doom, they actually seem to be disappointed that the FED has acted -- FINALLY -- to prevent deflation and a severe recession. They are angered that the FED no longer sees its primary responsibility to be enhancing the buying power of creditors' income streams. (Thank you, forthcoming presidential election).

The rationalization behind which these folks conceal their true motivations and emotions is that the FED is repeating its error of 2001 and 2002, and will create the basis for new bubbles.

This, in our view, is rank nonsense. The current situation is not, in our assessment, remotely comparable to that which existed in the early years of the decade. Today, house prices are in a bear market the likes of which we have not seen since the 1930s. The banking system is in serious distress, and the unfolding credit contraction confronts the debt-laden household sector with disaster, and the overall economy with serious deterioration. It is imperative to contain this situation. While a deflationary downturn and a Japanese-style economy may be low probability events, they are low probability/ultra catastrophic events. Insurance needs to be excessive, rather than minimal. Moreover, a serious recession is NOT a low probability event.

In point of fact, what the Chairman did -- BELATEDLY, TO BE SURE -- was take the first necessary steps to contain a potentially calamitous deflationary collapse. The FED is now acting pragmatically, in accord with its legal mandate. Hopefully, we can avert the sort of bloodbath the inflation-phobes seem to long for. The inflation-phobes fail to realize that the credit bubble CANNOT BE ALLOWED TO UNWIND. If it does, our economy will look like Japan's. In Japan, they speak of "the lost decade." (Two lost decades, actually). Is that what we want here?

The issue is not how to unwind the credit bubble, but how to PREVENT it from unwinding. The imperative is to MANAGE the bubble, NOT puncture it.