2007-09-18

Why Bernanke shouldn't blink

Imagine this situation: You have a friend who spends money like it is going out of fashion. All he does is buy things or invests them in crazy schemes. But in order to fund his spendthrift ways he needs to borrow money from his family and from friends like you.

One day your friend comes up to you. He is in a parlous state. He has lost all his money on failed investments. He owes so much money that some of his belongings have been repossessed already.

You shake your head at his story but you can't help but feel as though your friend is entirely to blame for his situation. You knew the warning signs were there and you're miffed at the fact that the ten thousand dollars he owes you may never come back.

You also know what he should do. He should cut his spending and live more frugally. He should divert most if not all of his remaining income into paying off his debt. You know that this process will be hard for him, but before you can say anything he asks you: "So, are you going to lend me money to cover my costs? Come ON man!".

What would you do?

By the time you read this, Ben Bernanke may have publicly announced a cut in official interest rates. To me, this is the complete opposite of what should happen. If you haven't worked out my anecdote already, the spendthrift friend is the market, who is reeling from the Subprime meltdown. You, of course, represent the Federal Reserve bank.

I'm a great believer that economics is actually simpler than what most folks think. I believe that the anecdote I have shared is true both in its micro and macro form - the best way to make people treat their money properly is by treating it seriously. This is as true for the poverty-stricken underemployed worker in Michigan as it is for the Wall Street stockbrokers who command eight figure salaries.

To cut interest rates would, in this case, be the same as lending your spendthrift and near-bankrupt friend more money. The Subprime meltdown, which is likely to plunge America and much of the world into recession, is a result of market failure. Easy money and easy credit have distorted the market's ability to spend and invest wisely.

But the market is, of course, demanding that Bernanke cut rates. "Come ON man!" they are saying to him "we'll be ruined if you don't cough up!".

It seems to me that the market's argument is that the cause of the problem is its solution. If easy money and easy credit have caused the market to go haywire, then the solution is more easy money and more easy credit. To me, this makes as much sense as a heroin addict arguing that the best way for him to get off drugs is to have another hit of heroin.

But in the anecdote you have the chance to say to your friend "No! I am not going to help you in this. The best thing for you to do is stop spending like it is going out of style and to stop investing money in crazy things! You have to cut your spending and live frugally until you pay off your debts!".

If Bernanke and the Federal Reserve wish to act in the best interests of America and make the best decision then they will decide to, at the very least, keep rates where they are. This may not be popular, but it will be the right thing to do. The market needs to learn restraint and the best way to do it at the moment is through frugality and austerity.

Bernanke has two choices: He can be a Greenspan or he can be a Volcker. If he chooses to be another Alan Greenspan he will cut rates, bask in the glory of sharemarket highs and then, in his retirement, be reviled for being part of America's poverty. If he chooses to be a Paul Volcker he will, like Volcker did in 1980-81, refuse to blink as he acted for the good of America's economy. Volcker's actions were instrumental in bringing about a protracted recession, but were also responsible for bringing about sanity into the world economy for some years afterwards.

If Bernanke wants to be as courageous as Volcker then he will keep rates as they are or even raise them. By doing this he will, no doubt, help bring about a global downturn over the next 18 months... but at least he would have done the right thing and helped bring America's (and the world's) economy back into balance.

Update:
Bernanke gave a 50 basis point blink.


© 2007 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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3 comments:

Dave Lankshear said...

I think I understand what you are saying about monetary policy and the loans meltdown, but isn't a loans meltdown inevitable anyway?

Remember what I posted on your other thread... that basically, the peakniks say there is to much debt to ever pay it off.

(From the other post...)

As Dr John Hermann writes for the CSIRO Sustainability Network (Number 55E PDF),

In a nutshell: Available statistics reveal that the total net debt of society tends to be significantly larger than the magnitude of the money supply. The origin of this discrepancy can be traced to the compounding of interest; and the ongoing need to pay it drives a large part of economic growth. The end result is an unnecessary level of production and consumption, with its associated destructive social and environmental consequences.

One Salient Oversight said...

but isn't a loans meltdown inevitable anyway?

In the current situation you could argue that it was inevitable. I remember arguing a few years ago with you that the whole property market thing would come crashing down one day.

My concern is not just harm minimisation - it is also trying to solve the problem in the first place.

I'm not sure if I agree with Hermann's quote. Even if debt is huge there are many ways to write it off. I'm sure you as a business owner have had to write off some debts.

Besides, if the world economy is continually shrinking then the only way to keep deflation at bay would be money printing, which sort of solves much of the debt problem.

Dave Lankshear said...

I forgot to say, I really liked the Bernanke analogy in your article. Cool. Don't lend that crack-dealing market any money!!!

My problem with economics is that I'm still trying to visualize a stable state economy and just can't. As long as exponential growth propels our debt burdens ever forward, we will be forced to accept economic growth, which of course is causing peak everything over the next 20 years.

It seems we are destined to lurch from one boom and bust cycle to another because of the very system that creates our money. If we are going to be happy with loaning "money" into existence that has to be paid back at an exponential rate, then we also ought to be "happy" with the consequences — namely, ecological destruction as more resources are consumed and habitats destroyed as we attempt to pay back this ever larger societal debt burden with an ever larger economy to eventually make that money loaned into existence mean something.

If we are going to create money this way, then we are going to have to get used to "writing off debts", regularly. What systems are in place to do so? I'd love the Bendigo bank to write off my mortgage debt, but I kind of want to keep living in the house as well.

What systems are in place for major banks to regularly write off mortgage debts? If the debt doubles every decade, are they going to halve their mortgagees? We have hit the natural limits of the earth's capacity to support economic growth, and unless we can grow our economies in a virtual sense... I just can't see how economic growth can continue.