Monetary Policy and Economic Shocks

Poor Ben Bernanke. You gotta feel for the poor guy. Faced with a whole bunch of economic problems all occurring at once he took the only option that seemed to be open to him - which was to create more money and postpone the inevitable.

In my famous (at least famous to me) 2005 "Perfect Storm" prediction, I gave four reasons why the US economy was heading for disaster:

1) Higher oil prices caused by Peak Oil.
2) An asset price bubble in the housing market that will pop and devastate the housing market.
3) A high current account deficit caused by an overvalued US dollar that will eventually fall.
4) High levels of Federal government debt caused by budget deficits.

With all these shocks hitting the US at once, what could have been done in the last 12 months to soften the blow? Would there have been any fiscal or monetary policy that would have worked?

No - not in my opinion. Moreover there is no point trying to limit the damage because the tools at our disposal to limit the damage can't handle the current crisis. We are in a crisis similar to that of the 1970s - whichever solution we choose the result will be bad.

One of the big problems with these four crises hitting now (and they will continue to hit for years to come) is that their effect upon monetary conditions is not uniform. Consider:

Peak Oil - inflationary
Housing Bubble - deflationary
US Dollar devaluation - inflationary
Public Debt - inflationary

If we were able to remove the housing bubble from the equation, then the solution to the crisis looks very much like raising interest rates - yet the housing bubble is very much the issue currently destroying wealth in the US. The other problems are certainly present, but their impact is not as strong. Not yet, anyway.

Yet it might be tempting for people to argue that "well, if the housing bubble popping is deflationary, the surely the inflationary effects of high oil prices will actually help".

But, as Milton Friedman told us, "Inflation is always and everywhere a monetary phenomenon." If one economic shock causes inflation and another economic shock causes deflation, the fact that each cancels out the other's monetary effects really means nothing - it just means the economy collapses without any inflationary or deflationary effects at all.

I've been trying to scour my mind for an image or an illustration that explains this. This is the only one that has come to mind:

Imagine you own a house on a flood plain. One day, your house catches on fire. At exactly the same moment, a massive rainstorm hits upriver and causes a flood. You look at your burning house and think "Thank goodness, some water to put the fire out". But the flood is only one metre deep - enough to cause major damage to the bottom half of your house. Meanwhile the top half of your house burns away and no fire engine can get to you to put it out. So the top half of your house burns up while the bottom half rots away underwater.

The fact that the housing bubble is deflationary does not mean that inflation caused by high oil prices fixes it. After all, it is quite possible that house prices will fall greatly while everything else in an economy rises horribly. No, instead we have multiple shocks hitting the economy and no way of mitigating them. The property bubble popping may have flooded your house, but the high oil prices are burning up the roof.

Many econ-bloggers have firm opinions of what is going on. Mish argues for a deflationary hit and pooh-poohs the idea of a stagflationary environment. Not many others seem to adhere to an inflationary or stagflationary point of view. The deflationists (such as Mish and PGL at Angry Bear) argue for standard monetary and fiscal stimulation.

Since I've spent time discussing the problem of monetary policy, I should also make a few points about fiscal policy and its limits. If the US government (under Congress and Bush) had actually been fiscally prudent since 2001, any fiscal stimulation plan would have some teeth to it. But since net public debt is now so high in the US (60% of GDP if I remember rightly), any attempt to run even larger deficits by the federal government will be met with even higher interest rates over the medium term, along with more current account blowouts which will shake even further the confidence that investors have in the US Dollar. That is why I have labelled "Public Debt" as having an inflationary effect earlier in this article.

Think back to the 1970s and the problems we had with inflation back then. Ian Macfarlane, the former governor of the Reserve Bank of Australia, helpfully pointed out in a series of lectures that inflation was starting to be a problem far earlier than popularly thought. He pointed out that inflation became a problem in the mid 1960s and was not caused by the oil shocks that hit the world economy in the 1970s. This, of course, is meaningful, because it shows that inflationary pressures were being generated by an overheating world economy and were thus what we would identify now as a normal part of the business cycle (high growth, low unemployment, rising inflation). Of course, when the oil shocks hit, they destabilised most industrialised nations. By themselves they caused an economic downturn along with higher levels of unemployment. But, as all former lovers of the Phillips Curve lament, the inflationary effect of the shock confused policy makers in trying to work out the best solution. In the end, fifteen years of inflation and multiple recessions was brought to a very painful close by Volcker's interest rate hammer.

As I pointed out back in 2005, the "Perfect Storm" which is now happening is likely to plunge America - and the world - into a protracted recession. There is a chance that this may be the worst economic downturn since the great depression. Yet I would argue that the problem will not be the quickly rising unemployment rates, nor quarterly GDP in minus figures, nor losses reported by corporations, nor plunging share prices - all those things will happen, but they happen in all recessions. What will typify this particular recession will be felt not now nor in the next 6-12 months but in the next 3-5 years. It will be felt in the rise of long term unemployed, it will be felt in stagnant GDP growth quarter after quarter, it will be felt in corporations releasing less than impressive balance sheets and in share prices sitting around doing nothing. It will, in the words of Paul Krugman, end up being an "L-ish" phenomena rather than a "V" shaped recovery.

With this before us, what can we do? Monetary and fiscal tools are pretty much powerless to stop the downturn or even limit it. Moreover, if Bernanke and Congress use them unwisely they may make things worse. In the end, therefore, the only thing I think is a viable solution is for monetary policy to be used simply to control inflation and not be concerned much with economic growth - which will, by ignoring it, be the best thing to help promote it. Using monetary policy to stimulate the economy because a recession is underway is no excuse when inflation is already too high. For fiscal policy the only real solution is to limit the deficit in the short term and erase it in the medium-long term. This won't help now - but it will help to make things better later. This, of course, is counter-intuitive, but I would argue that to increase public debt when debt levels are already unsustainable will make things worse over the long run.