Crisis prevention in hindsight

I'm in dot point mode today. Let me start with this one.

• If interest rates were higher in the past, the current crisis would not be so dangerous.
• If interest rates had been higher for the past 2-3 decades, this crisis would have been averted entirely.

Now, why do I say this? Well, let me just point out one important fact:

• Higher interest rates lead to higher rates savings because money becomes more valuable in relation to the goods and services it is exchanged for.
  

That, of course, is a point I argued in yesterday's post. Now one of the great ironies of economics is that problems are often solutions, and solutions are often problems. Sometimes in order to prevent something from occurring, you need to encourage it to occur. Now that might seem strange, but let me point out another important fact:

• The current crisis is occurring because the market has now decided to start saving.

Yes, that's right. The US economy has decided that it has had enough with spending and it has now decided to start saving. It has decided that it has had enough of borrowing.

But hang on! If I've been arguing that higher interest rates and thus increased savings rates would have prevented the crisis, am I now saying that the current crisis is due to increased saving? Well, yes - the solution is often the problem.

But let me explain this further. Imagine if the current crisis could be diluted somehow - so rather than one enormous credit crunch and market crash hitting now, that somehow this pain and misery could have been stretched out and diluted. If we give a 20 year time line, for example, imagine if this economic crisis was broken up into 20 pieces and then issued to each year of the past 20 years.

Keep that thought in mind - and that is what higher interest rates would have done.

Look at the following graph. This graph shows the effective federal funds rate (interest rates) in blue, while inflation is in red:

Now let's imagine that interest rates were higher since 1980. This would result in a negative relationship with inflation, with interest rates going up and inflation going down. In terms of the graph the blue line would be higher and the red line would be lower.

But I would argue that had monetary policy been more stricter, and inflation been lower, since the end of the 1980s recession, the result would have been, at the very least, mild recessions in the early 1990s, early 2000s and the one occurring now. In fact, those three recessions might well have never occurred.

And that is why I am an inflation hawk. A recession is always a period in economic history when, for whatever reason, the market rushes back to save money. If interest rates were higher and inflation rates lower, the market would never have needed a recessionary correction in the first place. The price to pay for this would be lower GDP growth but, in hindsight, that is a good thing. So here's another dot point:

• Higher interest rates = lower inflation = lower GDP growth = less chance of a recession.

Over the years many central banks have instituted inflation targets. While the Federal Reserve did not have one, in practice the Fed did raise rates when inflation approached 4% or more.

But if we assume that recessions could have been reduced in severity or even completely negated if interest rates were higher and inflation rates lower, then the usefulness of inflation targets needs to be reassessed. In hindsight, it now seems clear that these inflation targets were actually too accommodating.

And that leads to my last dot point for today:

• Absolute Price Stability - an inflation rate that averages zero over the course of the business cycle - should be the ultimate goal of monetary policy.

For regular readers, you saw that coming didn't you?

This morning as I lay in bed I was listening to comments made by some person from The Daily Telegraph, one of Rupert Murdoch's tabloids here in Australia. In the past year or two, the Tele has been waging a war against the Reserve Bank. The person on the radio this morning spoke disparagingly about the usefulness of monetary policy, saying that it was a crude tool like a hammer. He also said that monetary policy was relied upon too much in the past and is no longer working.

In the current crisis, monetary policy has only limited usefulness - that much I agree with. But I would argue strongly that the age of monetary policy is not over yet. Monetary policy is not intended to "solve" any crises, but to prevent them from occurring in the first place. Moreover, the current crisis was not due to an inherent failure in monetary policy, but a failure to use monetary policy wisely.

To use an analogy - the car has crashed and people are lying dead and injured. People like me who support monetary policy would blame the driver. Others who disparage monetary policy blame the design of the car.

In the midst of the current crisis I am absolutely certain that no government or central bank has the ability to stop the market stampede. Steps can be made to reduce the pain, but this crisis cannot be solved. What we can do is learn from it to ensure that no similar crisis occurs again.

Absolute Price Stability is a way to ensure that such a crisis never repeats. If this monetary policy was implemented worldwide, the result would be a stronger and more sustainable international economy.