Solving Australia's House Price Crisis

The Problem

I used to believe that one of the most solid economic laws that can ever be argued for is the notion that "what goes up must come down". In other words, asset price bubbles (such as property or sharemarket over-investment) will naturally fall back to realistic levels. Tulip mania, the 1929 Stock Market crash... all the evidence is there.

But no longer. Asset price growth in property and shares has continued. Even the correction inherent in 2008 Global Financial Crisis has been exceeded in some areas. I am referring especially in this case to Australia's property price bubble.

Current Monetary Policy, which has evened out the business cycle, is probably to blame here. Controlling levels of inflation by adjusting interest rates has been one of the success stories of the world's post-1980 economy. But modern measures of inflation don't take asset price growth into account. A low inflation economy with a growing asset price bubble has been the norm in many western economies for decades.

One Solution: Higher Interest Rates?

One solution would be to factor in asset price bubbles into inflation measurements. As an indicator, this is fine. But what should be the central bank's response to this changed rate of inflation? Would it be wise to increase interest rates to push down a growing asset price bubble when the rest of the economy probably won't handle such a change? After all, if, say, the Reserve Bank of Australia (RBA) increases interest rates to deal with the growing property bubble, would the effects on the non-property sector of the economy result in a bad recession? Would the cure be worse than the disease?

Of course the real problem here is that interest rates have a very broad effect on the economy. This is inherent to current monetary policy and it can't be avoided. This doesn't mean that adjusting interest rates are somehow a bad thing - there are obviously times when a broad adjustment is going to be required.

But in the case of asset price bubbles, especially in the case of Australia's property market, a different approach is needed. One in which specific monetary goals in that particular market need to have external adjustment. A micro-prudential policy, probably with a dash of micro-monetary policy as well.

A Better Solution: Keep Property Prices Stable

In the case of Australia's overvalued (and now deflating) property market, it is important to neither keep prices rising nor to let prices fall. Property should retain its value over the long term, adjusted for inflation.

For this, an inflation-adjusted property price index should be created, with regular monthly updates. With the index starting at 100, the goal should be a long term price index that has peaks and troughs, but remains at 100 on average.

The advantage of stable property prices is threefold.

Firstly, it means that those who invest in housing will be investing in something that retains its value. All forms of investment exist because people with money wish to gain more. If property prices retain their real value over the long term, people will feel safe investing in them. Obviously such investment needs to be compared to other forms of investment, and the risk/rewards that such investments have, in order for the market to respond appropriately.

Secondly, it creates a disincentive for speculation. Any form of asset price growth leads to speculators who are not so much concerned with actual assets, but whether they can profit from the process of buying low and selling high. Speculation has its place in an economy, but asset price growth in shares or property turns investors into speculators. This results in profits derived from the process rather than the utility of the asset being invested in, and creates a parasitic sort of investment class. This has been one of the great problems in the world's post-1980 economy, with huge asset price bubbles in both shares and property coexisting with lower levels of GDP growth. But if an asset is neither growing nor shrinking in real value over the long term, there is less incentive for speculation.

Thirdly, assuming wages keep rising, it makes for more affordable property prices over the long term. If an economy has rising wages but property prices remain stable, then, by definition, property prices become more affordable. My belief is that property prices are too high, and there are plenty of stories and statistics out there which show how difficult it is for younger people to afford to buy their own accommodation. A long term increase in housing affordability is the best solution here.

So how would this be achieved?

The real property price index would, like the inflation index, be used by a central bank to determine whether to remove or inject liquidity into that specific market. Currently, the adjustment of interest rates is the only current solution, and as I have pointed out above, its usefulness is in its broad effect, not in its narrow effect, making its use problematic in the case of stabilising property prices.

The solution would require a central bank to use two policy tools to keep prices stable. Micro-prudential policy tools would be used to stabilse the peaks and troughs of a typical business cycle, while micro-monetary tools would be used during a serious drop in prices.

Micro-prudential tools

If the index is showing a substantial change in house prices, then the Central Bank would adjust prudential rules that govern mortgages, by increasing or decreasing the minimum deposit required for mortgage holders. This would be based on lending laws that would apply across the entire property market, ensuring that people applying for a mortgage would have to increase or decrease the initial deposit.

In a market of increasing property prices, these micro-prudential rules would have the effect of denying liquidity to the property market, resulting in less money available to invest, and thus cause a drop in prices.

The same micro-prudential policy can be used when prices begin to fall. By decreasing deposit ratios, more liquidity from investors would enter into the market, causing prices to rise.

Micro-monetary tools

In the case of a substantial drop in prices, however, direct monetary policy would be required. Even if micro-prudential deposit rates were dropped to zero, economic conditions might still be so bad that prices keep dropping. When this occurs, the central bank could invest directly in the market itself. This would involve the central bank creating money by fiat, and then using it to purchase property. This is similar to Ben Bernanke's "money by helicopter" theory, except that instead of giving free money out to everyone, fiat money is used by a central bank to directly enter a market. Once prices have begun to stabilise at the 100 index level, the central bank can then begin gradually selling off this property, with any money it gains from the process being "de-fiated" into nonexistence.

Of course such a targeted policy would impact the wider economy, and inflation rates will be impacted by the specific policy tools that the central bank would use to stabilise prices. But these broader effects would best be served by broader policy tools - ie, interest rates.

Summary

To summarise, the current property price bubble in Australia can be solved through the following means:

1. Set up an index which measures property prices adjusted for inflation and update it monthly. This would require work on behalf of the Australian Bureau of Statistics and funds to create it.

2. Grant the Reserve Bank of Australia the power to determine mortgage deposit rates, requiring all registered mortgage lenders to set a minimum rate of deposit. If the rate is set at, say, 20%, this would mean that someone wanting a $1 million mortgage would have to have saved a $200k deposit.

3. Grant the RBA the power to change mortgage deposit rates.

4. Give the RBA the directive that mortgage deposit rates should be adjusted in order to keep real property prices stable over the long term. Specifically, this would be an index number of 100 averaged out over the long term.

5. Grant the RBA the power to purchase property with money created by fiat as another way to keep real property prices stable.

6. Property so purchased by the RBA will be maintained and managed by a separate government body until such time as the RBA sells the property.

7. Property directly purchased by the RBA will be sold once prices have stabilised.

8. Money generated by the RBA's selling of properties is "de-fiated" into nonexistence, and is not part of general government revenue.

Why didn't it work?

Marge, I agree with you -- in theory. In theory, communism works. In theory.
- Homer Simpson.

Communism failed for many reasons, not least due to the effects of Stalin's dictatorship. Yet modern communists are quick to point out that Communism as a theory doesn't exclude free and fair elections, nor does it by nature result in a dictatorship of the sort we saw under Stalin. And you know what? They're right. But there's no point protesting and saying "True Communism has never been implemented" when the simple fact is that a massive long-term communist experiment was tried in Russia between 1917 and 1991 and, while it did lead to many notable successes (Nuclear weapons, Space Program, recognised superpower) we need to remember that it did collapse.

One of the more interesting subjects I studied at Macquarie University was "Modern Russian History", taught by David Christian. Christian was a communist in his youth and did his post-grad work in Leningrad in the early 1970s. Over time he became a critic of communism - not so much because of an ideological shift but because he came to realise that, as an economic system, it failed to deliver what it promised. He pointed out that whenever the Soviet Union wanted to increase the production of goods (eg wheat, tractors, AK-47s) it would simply increase the amount of factories or farming land to achieve it. To put it mathematically, if x is the amount of land set aside for growing wheat, and y is the output of wheat, then the path to 2y is to 2x - doubling the output meant doubling the means of production. The problem arose when there was no more room for increasing output - short of felling Siberian forests and forcing women to have lots of babies.

Capitalism, by contrast, (and this is Christian's argument), sought to increase production by increasing efficiency and productivity - and the way this was done was through profit driven innovation. Rather than being content with 2x = 2y, capitalism sought to change the equation to read x = 2y, to increase production without increasing labour or space or equipment by the same proportion. Christian therefore concluded that, in the "war of ideologies" that typified the post-war world, Capitalism had won because it was able to (eventually) deliver better and cheaper goods and services for people. Christian did not embrace capitalism, though - he still saw within industrial capitalism the exploitation and suffering of workers and thus the seeds of dissent that Marx saw. (note: this is my summary from memory of what Christian argues in his book Imperial and Soviet Russia).

Christian's arguments are very cogent because he steers away from the Stalinistic dictatorship / loss of democracy line of argument that so many people today use to explain Communism's failure. While it is no doubt true that Stalin and the lack of democracy were serious blights upon communism, their presence alone did not lead to communism's collapse. There are three nations today which espouse communism - China, North Korea and Cuba. Of those three, only one (North Korea) has remained ideologically true. China and Cuba abandoned Communist principles decades ago, and these nations have essentially become undemocratic societies with varying degrees of free market activity and private ownership of wealth (anathema to pure communism). By contrast, North Korea continues to be the beacon of hope for the workers of the world, and what a terrible, inefficient, controlling and frightening beacon that has turned out to be.

So all hail capitalism? Not quite, of course. I have often in the past compared the misguided ideological purity of the communist party to the ideological purity of conservatism - especially political conservatism in the United States. This is one of those times.

Modern American Conservatism (modern) can be traced back to the election of Ronald Reagan in 1981. For the past 28 years, US political discourse has been dominated by conservative beliefs and ideals. Yet in that time we have not only seen lower GDP growth than the previous period, but also a massive shift of wealth to the rich. Real median household income growth since 1981 has, according to the Krugmeister, been around 0.7% per year. Moreover, US Census figures clearly show that median income has stagnated since 2000, while the top 5% of wage earners have increased their income by 25% over the same period.

Then we add to this the ridiculous level of credit market debt as a percentage of GDP, which shows just how much of America's current wealth is illusionary. Also add the massive expansion of public debt under Reagan and both Bushes, the financial corruption of conservative politicians in recent years, the FEMA debacle in New Orleans and, of course, the housing bubble and credit market collapse which has led the world into the worst economic downturn since the great depression. Not to mention the conservative controlled Federal Reserve Bank (Alan Greenspan and Ben Bernanke were both appointed by conservative Presidents. Alan Greenspan was a disciple of conservative philosopher Ayn Rand).

Conservatives will, of course, offer all sorts of retorts to these problems. Conservatism doesn't condone corruption; conservatism demands fiscal prudence; conservatism demands good government. Yet there is no doubt that conservatives held onto political power during the period of history in which corruption, fiscal stupidity and government incompetence occurred. Arguing that conservatism and free market capitalism wasn't really applied during this period is pretty much the same sort of argument as those who say that the USSR never practised "real" communism.

Nevertheless, I am sympathetic to those who do argue that conservatism and free market capitalism wasn't really applied. I am also sympathetic to those who say that the USSR never practised real communism too. Yet there is no doubt that the conservatives who today complain that conservatism wasn't really tried are the same conservatives who enthusiastically voted for conservative politicians over a long period of time and supported the conservatives in power when things appeared to be going well. When asking the question "why didn't it work?", conservatives need to examine themselves and their own failures rather than blaming others - in short, they should take responsibility for their own actions (or lack of them) rather than threatening civil war if they don't get their way.

Ultimately the answer, I think, lies in two areas:

1. No pure ideology can be practised, so we should embrace a more centrist political position (which is why I describe myself as an Ordoliberal).
2. Politics corrupts, so stricter anti-corruption policies should be initiated on politicians at all levels (which is why I like the idea of Demarchy).

Living for today makes for bad monetary policy

Ben Bernanke has said that US interest rates will remain where they are - at the historically low 0.25% - for the time being. By contrast, Australia's interest rates have been going up. What's going on?

The only real reason to adjust interest rates is in response to inflationary pressures. The latest CPI figures from the US indicate that prices have remained relatively stable over the past month (+0.2%) while the 12 month result is still negative (-1.3%). From that data alone, keeping interest rates where they are appears to be the right move.

But as regular readers know, I'm not a fan of Ben Bernanke. Bernanke not only misjudged the severity of the current downturn while it was happening, he was also partly responsible for the creation of the downturn, being part of the Fed board that approved Greenspan's negative real interest rate regime. My lack of confidence in him knows no bounds.

Good monetary policy doesn't just depend upon current data - it should also look to the future, and the future for the US Dollar is not bright. I have predicted a dollar crash for many years now and while I am happy to be wrong in predicting the when, I stand behind my predictions of what will happen. Whenever currencies drop in value, the result is more expensive imports which is then translated into higher inflation. Inflation can only be dealt with by restricting money creation, which means that interest rates will have to rise. In short, America's future involves inflation.

Given that my predictions about a US dollar crash are correct, Bernanke's decision to keep interest rates low smack of reactivity rather than proactivity. Had Bernake raised interest rates 25 basis points, he would be acting in response to a future event. Instead, he's stuck in the present.

Such activity is not new. The negative real interest rate regime under Greenspan between 2002 and 2005 was based upon present concerns and ignoring the potential for future problems. It also ignored the teachings of history - that negative real interest rates were a recipe for financial and economic disaster (a point which The Washington Consensus makes). If a dollar crash is coming (and the current data shows nothing but a downward trend), then Bernanke should be doing better - adjusting interest rates in response to a future inflationary environment makes perfect sense.

In which the incompetent are rewarded by the incompetent?

Barack Obama is in the process of reappointing Ben Bernanke as governor of the Federal Reserve. This fact has led me to wonder whether Obama is either ignorant, a fool or an industry shill. There are no other choices.

Bernanke is one of the people responsible for the current crisis. As a member of the FOMC that approved injudicious interest rate lowering under Greenspan, he is jointly responsible for the property bubble which formed. I have argued that point here.

Bernanke has reacted to the crisis badly. First he didn't admit that there was a crisis and then, when the crisis was underway, argued that it was "contained". Again, look at the link above for the details.

Once he realised that things were bad, Bernanke, a student of the Great Depression, acted swiftly in increasing the money supply at a time when the money supply was tightening into deflation. This was not a terribly hard thing to do. Even I could've done it. In fact, since I was actually aware of the crisis years before Bernanke, I would've been able to take pre-emptory actions and done a better job. Yet it's Bernanke who gets the multi-million dollar salary while myself and others bang our heads against the wall in response to the stupidity of those who control vast sums of money.

So the question is - why did Obama not know this? Is he being shielded from reality by a bubble in a similar way that Bush was? Or maybe he has no idea of how economics works and thinks Ben has done a good job. Or maybe Obama is simply having his strings pulled by industry insiders. Whichever one it is is hardly encouraging.

A thought

Ben Bernanke is trying to wage war against the Great Depression.

The problem is, as many prospectuses say, "past performance is not an indicator of future performance".

I don't think Bernanke is factoring in the great possibility of capital flight from the US - a process that would leave the US Dollar in tatters.

Ben Bernanke predicts end of recession

Ben Bernanke, the man who did not foresee the crisis, is now predicting its end:

"It depends a lot on the financial system," he replied. "The lesson of history is that you do not get a sustained economic recovery as long as the financial system is in crisis. We've seen some progress in the financial markets, absolutely. But until we get that stabilized and working normally, we're not gonna see recovery. But we do have a plan. We're working on it. And I do think that we will get it stabilized, and we'll see the recession coming to an end probably this year. We'll see recovery beginning next year. And it will pick up steam over time."

Diversionary tactics:

Bernanke obviously knows that he is in the firing line of blame for this crisis. But look who he blames:

"Let me just first say that of all the events and all of the things we've done in the last 18 months, the single one that makes me the angriest, that gives me the most angst, is the intervention with AIG. Here was a company that made all kinds of unconscionable bets. Then, when those bets went wrong, we had a situation where the failure of that company would have brought down the financial system," Bernanke said.

"You say it makes you angry?" Pelley asked.

"It makes me angry. I slammed the phone more than a few times on discussing AIG. I understand why the American people are angry. It's absolutely unfair that taxpayer dollars are going to prop up a company that made these terrible bets, that was operating out of the sight of regulators, but which we have no choice but the stabilize, or else risk enormous impact, not just in the financial system, but on the whole U.S. economy," Bernanke explained.

AIG is one of many different financial institutions that made bad calls and ran close to the edge to gain more profit. Until the whole thing collapsed, we didn't know just how close to the edge these companies were. AIG, of course, deserves as much blame as it can get... but in Bernanke's case it diverts the attention away from his own failures.

Minimize failure:

"Does the Federal Reserve bear any responsibility for missing what was happening to the banks, as it was happening?" Pelley asked.

"Well, like other regulators, we probably could have done more. We've already done a lot of - put a lot of effort into reviewing our practices. And reviewing the bank's practices. We are trying to strengthen our regulation at every point that we can. So, I don't want to deny that we certainly could have done a better job, and others could have done a better job," Bernanke conceded.

Notice - nothing there about how the credit crisis caught Bernanke by surprise, asleep at the switch and with his pants down.

Why was it that so many of us knew that the whole thing was going to crash down while Mr B did not? He clearly stated in 2005 that there was no housing bubble.and when he finally admitted that one existed and had popped, he said that everything would be fine. Moreover, he still doesn't say much about Greenspan and the Fed's decision to pursue negative real interest rates between 2003 and 2005 (Bernanke was part of the Federal Reserve Board that made those decisions)

Bernanke is a smart man, but someone has to take the blame for the Fed's failure to foresee the current crisis. His errors of judgement are on the record. He must step down or be pushed.

A Deflationless Depression?

Logic can be a bad weapon when the equation isn't finished.

Think back to the Great Depression. Long lines of unemployment, years of economic contraction, suffering, etc.

One big thing that happened during that period was deflation - a continual falling of prices. Goods and services dropped in value on a daily basis.

The problem was chronic, and policy makers at the time either didn't know how to cure it, or didn't really see it as an important issue. In hindsight it was. Keynes rightfully argued that a good response would've been for the government to expand its operations and run a deficit, thus increasing economic growth and reinflating. Monetarists rightfully argued that interest rates at the time were too high and that increasing the money supply by lowering rates would've been a good solution. Ben Bernanke, in his study of the Depression, declared that there was always the option of merely creating money ex nihilo and throwing it around until deflation disappeared (and thus was born his nickname "Helicopter Ben").

So... here we are on the cusp of yet another potential depression. Ben is doing his best to keep deflation at bay - interest rates have dropped again, a process which acts to stimulate money growth. If the problem gets any worse Ben may have to warm up his helicopter and begin money bombing.

But will this solve the problem? Will the simple process of creating more money - which is balanced out by the market's deflationary money hoarding - do the trick? Is it simply a matter of monetary policy?

The answer to that, of course, is no. It will certainly help prevent exacerbating the problem, but we need to remember that the Great Depression was not simply a failure to keep prices stable.

At present, I would argue that our current set of policy tools and economic understanding is quite capable of coping with an economic upheaval similar to that which caused the Great Depression. Yet I would also argue that the upheaval we are experiencing now is twice as worse as the share price bubble bursting in 1929.

The basis for this argument is the below graph, which I mentioned back in July and which was instrumental in changing me from an "optimistic financial doomer" into a "pessimistic financial doomer":

The graph is sourced from this article at Naked Capitalism.

There is always something terribly frightening about any graph showing exponential growth as it plots something in the real world. "What goes up must go down" is the rule - and the current market crash seems to be following this principle.

I still cannot believe that total credit market debt is equivalent to around 350% of GDP. If that isn't frightening enough, look back the great depression years - the "spike" on the left hand side of the graph. This may, of course, be simply a Propter Hoc scenario - two bits of information that appear to be linked but aren't - but I honestly doubt it since we are comparing stats from the same area of study.

(Note: an example of a Propter Hoc fallacy would be to say that the decline in popularity of Spirographs has occurred while childhood literacy has dropped - thus creating the impression that declining literacy rates could be stopped by buying more Spirographs. The two areas of study - developmental psychology and sales figures - need more to link them than just sheer coincidence. In the case of the graph above and the instance of economic downturns, the information is linked in the area of financial statistics, thus making the correlation between the two more reliable).

If the graph is correct (and I trust Yves), then we are facing a financial situation many times worse than that which hit in 1929. Debt-based asset price bubbles (such as property or shares), when they go bust, leave a trail of deflationary and expanding debt.

It is important to look at the above graph and compare the Depression years with the years since 1980. The depression years saw debt increase to around 170% of GDP before the crash. The increase of the debt to 260% of GDP occurred after the crash and is most likely due to the deflationary spiral that the world economy went into (debt levels remained the same while GDP contracted sharply, thus increasing the share of debt to GDP).

What we have seen since 1980, however, has been a build-up of credit market debt to a level representing 350% of GDP. That is around twice the comparable amount of debt that was present before the 1929 crash. This means that we have further to go.

Think of it like this: The economy is a car ("automobile" for you yanks). In 1929 the car hit the wall at 100kph and crashed. Unfortunately no one knew how to fix the car properly after the crash, which meant that the problem got worse. Moreover, it took years of research and study to determine the best methods of fixing the car properly. Now that the car has hit the wall again, it is tempting to say "well we know how to fix it now" - except this time the car has hit the wall at 200kph.

And that goes back to the title of this article - a deflationless depression. I am absolutely certain that we have learned from the policy mistakes of the 1930s and we are able to prevent the world from going into a 1930s-type deflationary spiral. But we must also remember that our economy has hit the wall harder and faster than in 1929. We cannot assume that this will be of no consequence.

Monetary policy is, of course, an essential tool for running an economy properly. But monetary policy is best used as a preventative rather than a cure. The most effective form of monetary policy occurs when interest rates are raised or lowered in response to price signals while the economy is running along relatively smoothly. Emergencies like deflationary spirals or stagflation do require monetary intervention - but they still remain emergencies. It is obvious that central banks like the Federal Reserve need to step in and provide emergency assistance to an economy that has hit the wall - but the work that monetary policy does in those cases is not a cure, but merely a bandaging of wounds and a setting of broken bones. At some point the market ends up having to cure itself with bed rest.

It is entirely possible to have a deflationless downturn - just as the 1970s showed us that it is possible to have an economic contraction and high inflation at the same time. Whatever the Fed or the US government will do in response to the current crisis will never be enough to cure it but hopefully will be enough to limit the damage. After all, the last thing we need is for policy mistakes to make the situation worse.

America has no room for fiscal deficits

It says:

Wall Street rose more than 4 per cent overnight after US Federal Reserve chairman Ben Bernanke supported the implementation of another US Government stimulus package.

Dr Bernanke told a US Congressional committee that it should consider measures to help improve access to credit by consumers, businesses, and other borrowers, as the North American economy faces a protracted slowdown.

This is precisely the area that I differ with in regards to other econ-bloggers. A month ago I argued that the time had come to follow The Washington Consensus. This called for nations that in economic trouble to enact "fiscal policy discipline".

It's not as though I reject Keynesian policy at this point - in fact, I think the idea of running a deficit during hard economic times is an essential activity, all things being equal. The problem with this in America's case is that things are not equal.

It is popular for many econ-bloggers to remind us all of Hoover's mistake. Faced with the biggest economic collapse in history, Hoover exacerbated the situation by insisting on tax rises and spending cuts to ensure that the US government ran a balanced budget. At the same time, the Federal Reserve kept interest rates too high, making the situation even worse.

Thus, the logic goes, insisting on fiscal discipline during a recession is deadly. Paul Krugman thinks so, as does Ben Bernanke.

Well, allow me to disagree with the Nobel Laureate and the Reserve Chairman.

The situation the US finds itself in now is not completely analogous to the situation in 1930 onwards. For starters, the US in 1930 did not depend upon the actions of foreign investors as much as it does now. In 1930 (as far as I know) US treasuries were not being bought and sold by sovereign investors like the Bank of Japan or the Bank of England. Around $2.7 Trillion in US treasuries were owned by foreign investors - a number which represents approximately 20% of GDP.

The second problem that faces the US now is that public debt is already way too high. $6.06 Trillion in federal government debt is owed to the public - around 44% of GDP (and likely to get higher as the bailout, reduced tax revenue and contraction in GDP will increase that percentage).

Again, let me say that I am not against running deficits during recessions in ordinary circumstances. Hoover's decision to balance the budget was a wrong one, to be sure, as was ultra-tight monetary policy from the Fed in the 1930s as well.

But what I am saying is that the circumstances that the US is in today - namely already huge levels of public debt and a dependence upon foreign investors - makes the current economic crisis even worse. The fact that the US government already has unsustainable amounts of debt (due to a combination of Reagan and GW Bush) allows little, if any, room to move.

I have pointed out in earlier posts the danger of capital flight - when foreign investors flee from a country and, in the process, crash the currency. This happened to Russia and many Asian countries in the mid-late 1990s and the result for them was horrible. I vaguely remember the Russian central bank lifting rates to 100%.

If the US should increase its level of net government debt, the danger of capital flight will be increased markedly. There is every reason to believe that foreign investors' love affair with the US dollar might come to a sticky and bloody end if the US continues to borrow money to boost consumption.

Many might argue, however, that the US Dollar is too big to fall. The US Dollar is, after all, the world's reserve currency. All I can say to that is to look at the example of Enron or Lehman Brothers or Washington Mutual - huge companies that were in the top 30 biggest companies in the US. If these big companies can go bankrupt and collapse, then it stands to reason that international investors may eventually raise the level of risk associated with investing in the US, causing the Dollar to drop in response.

I have to say that too many American economists have been blinded by their Americocentricity - they have lived and studied so long within the US "bubble" that they are unable and/or unwilling to step outside of it and see the bigger picture. This is why Krugman and Bernanke - amongst others - are arguing so vociferously for more stimulus programs and bigger deficits. The fact is that they can't see how public debt levels are already unsustainable and the danger this poses both in terms of future fiscal restraint and US dollar values.

If capital flight does occur and the US dollar does crash, the result will be disastrous - what I often refer to as "financial armageddon". If you think the problems of the present are bad enough, they will be made 100% worse if the US dollar crashes.

Let me finish off here with a market example.

Let's say that Widgets Banking Corp, a nondescript but medium-sized efficient US bank, decides to purge itself of its debts, lay off half of its staff and cut costs. What would this do to its share price? Investors, seeing that the company has taken steps to minimise its losses, would reward this effort with higher share prices.

In the same way, if the US government made steps to purge itself of debts by slashing costs and increasing its revenue stream, international investors in the US Dollar would react by valuing the currency even more.

You see, the problem is that traditional Keynesian thinking has the government acting within a closed economic system. The problem is that the system is open. If the US government goes ahead with Bernanke's advice and runs even bigger deficits to boost consumption, the result is likely to be capital flight.

Frying pans and fire come to mind here.

Economic Crises still need price stability

I admit it - I'm not an inflation hawk, I'm an Inflation Mushroom Cloud Layin' (insert crass Oedipal phrase), (insert crass Oedipal phrase)!

I have spent the last few years arguing on this blog of the necessity of controlling inflation over and above what many policy makers would think is reasonable. On my own I developed the theory of Absolute Price Stability, which is the #1 Google search for the phrase, even though others had actually invented the idea long before I did.

To quickly summarise what I have said (in case you haven't been turned off yet by my recent goings-on about it), I believe in the following axioms:

• The value of money is solely due to its ability to determine the cost of goods and services and to be used as a way of exchange. It is a way of measuring the worth of economic activity in a quantifiable manner.
• Over-investment and under-investment bring about economic harm to a society.
• Investment in the wrong place and the failure to invest in the right place also bring economic harm to a society.
• When the value of money changes, the market (as households, businesses, individuals and government) will inevitably make poor decisions in regards to what to buy and sell, and what to invest in and borrow for.
• While the market will always be prone to errors in judgement, ensuring that the value of money remains constant will help minimise this risk.
• In order for the value of money to remain constant, monetary policy should now be focused upon Absolute Price Stability - whereby the value of money is affected neither by inflation nor by deflation.
• In practice, Absolute Price Stability is not about price fixing, but inflation fixing. Monetary policy should always ensure that neither inflation nor deflation permanently affect the value of money over the long term. Short term experiences of inflation and deflation are to be expected, but over the long term, monetary policy should ensure that money's average value remains constant.

At present the economic world is suffering a massive credit crunch. In the past I have argued that inflation will continue to bedevil the world even though a recession takes place. I was wrong. I was predicting a different recession to the one now being experienced. Moreover, the one being experienced now is far more dangerous because it now seems to be an unwinding of the entire financial system that the world has been operating for decades. In this sense, the recession was always going to arrive. Moreover, two of the conditions of the recession that I was predicting (fiscal irresponsibility by the US government and the effects of Peak Oil - see here) are still major threats that need to be taken into consideration.

Absolute Price Stability, however, doesn't just mean no inflation. It also means no deflation. Financial conditions have deteriorated so badly in the last month that the only real result will be deflation.¹ While the stupidity of the Fed between 2002-2005 and the fiscal ineptitude of the White House and Congress between 2001-2008 has allowed inflation to grow, we are now seeing the results of those decisions - essentially what goes up (inflation) must come down (deflation).

If the Consumer Price Index begins to show increased deflation (as I think it will - the September figures are due soon) then the only real solution is for the Fed to begin seigniorage - money creation. This is the emergency solution that Ben Bernanke has written about previously, from which he derives his nickname "Helicopter Ben" - the idea being that deflation can be solved by simply throwing money everywhere.

In theory, a central bank can create and control an infinite amount of money. Bernanke and others in the Fed could, if they choose, create $100 Quadrillion dollars out of thin air. The idea that deflation can't be solved is incorrect.

And this is where Absolute Price Stability comes in. If this sort of policy is introduced, the Fed (and other central banks) could quite easily control deflation by creating money and buying back bonds. This would not be done randomly or stupidly - the last thing we need is a Weimar America - but certainly the sterilizing effect of deflation can be balanced through judicious seigniorage. In fact, some of this money creation could be used in the form of stimulus checks or given to the unemployed - it doesn't have to go towards corporations or financial firms.

I'm saying all this not just to push my idea of Absolute Price Stability (which I think will help solve the current crisis and prevent many from occurring ever again) but also to point out that while I have described myself as the "Inflation Mushroom cloud laying (insert crass Oedipal phrase), (insert crass Oedipal phrase)!", the reality is that I am just as opposed to deflation as inflation. I am not advocating some form of permanent deflation - that would be crazy - but instead the belief that money itself is best used when it retains its value.

Moreover, I believe that such a policy is best practised universally. There is only one country which practices Absolute Price Stability and that is Japan (Mark Thoma confirmed that with me once on a comments thread at Economist's View) - yet Japan is sliding into recession too. The reason is that Japan, despite practising Absolute Price Stability, is strongly connected to the world market - which means that a problem in the world market will also affect Japan. But if all countries practised Absolute Price Stability - and made it into an international treaty - then the world would be far less likely to suffer the sort of upheavals that we are experiencing now.
--------------
1 - Unless the US Dollar crashes of course (see Krugman!). But let's ignore that for a moment.

Schiff vs Laffer

This video clip is just incredible (19mb, nearly 9 minutes long). It shows a debate between economic pessimist Peter Schiff and the over-optimistic Arthur "Supply Side" Laffer. It was recorded on 28 August 2006 - over two years ago.

In this clip, Schiff argues that the housing market will eventually pop and a recession is around the corner. He argues that America has borrowed and spent too much and needs to return to producing things and saving money.

Arthur Laffer argues that the economy is going fine, thank you very much, and that there is no need to worry.

Laffer, it must be said, is the intellectual basis of Supply Side Economics and popularized the "Laffer Curve".

Schiff is an Austrian Economist, a school of economic thought that I respect and have much in common with (though I disagree with some of it).

The Botched Big Bailout

Well it seems that the Big Bailout^TM is getting harder and harder to pass Congress. I haven't been looking for the finer details, but I pretty much gather that the major problems are:

• The nature of the bailout, which seems to be throwing money at banks and financial institutions rather than buying them out (which was the Swedish model).
• The idea that bad behaviour should be rewarded.
• The idea that the US government is engaging in the worst sort of "socialism for the rich".
• The threat posed to public debt, which is already too high.
• The belief that the market should simply run its course.
• The fear that the bailout will have little or no impact on the problem.
• The fear that the bailout grants too much power to the US Treasury.
  

There is a sizeable group of Republicans who are refusing to pass the bailout in its current form. Essentially the issue is one of trust - is Hank Paulson's bailout sufficient enough to solve the problem or not?

My personal opinion is that both sides of the argument have merit. The Democrats and Republicans who support the bailout are doing so because they truly fear the consequences of the current economic crisis. The Republicans opposing the bailout are doing so out of fear that the consequences of the bailout will outweigh the benefits.

This is not a time for partisanship, yet I don't think anyone is being too partisan here. It's not that I have confidence that Congress will make the decision (I don't), but, in this particular case, I am not questioning their motives. There is enough fear and doubt on both sides to make the decision hard to make.

So let me offer some level of solution, not that anyone will listen to me, of course.

I believe that some sort of bailout is needed. I'm not convinced that the Paulson plan is the best way to do it, which is why it is good that Congress is debating these measures. The best outcomes we can possibly hope for is for the money to give financial institutions some breathing space while the economy tanks and, eventually, recovers enough so that the billions used in the bailout get paid back over time. In other words, the bailout has to take resources from the future in order to secure the present.

The more I look at the Swedish solution, the better it looks. Rather than throwing money at the problem (which seems to be the Paulson plan), it would be better if the government bought out the struggling financial firms - in other words, nationalization. This would allow the institutions to keep running and providing (albeit limited) levels of credit without the threat of bankruptcy. Yet the nationalization will be temporary - lasting no more than ten years maximum. In that time the financial company is made leaner and meaner and then eventually unleashed back into the market when the Federal government fully privatizes it - with the proceeds from privatization paying back the debt accrued from the original buyout.

Moreover, I suggested earlier the importance of instituting some form of market capitalization tax as a means to pay back the debt as well. I am absolutely certain that the Swedish model I propose in the previous paragraph will NOT result in all of debt being paid off. Therefore another form of revenue should be instituted. I am loathe to suggest income tax rises since I believe that the people of America should be the last to directly pay tax to save Wall Street. A market capitalization tax (Market capitalization is when a listed company's share price is multiplied by the amount of shares) would be a broad-based tax upon all publicly owned companies that would help pay off the debt. In essence, future Wall Street profits would be taxed to pay for the present rescue - which is why I describe it as "taking resources from the future to secure the present".

I gotta tell you though that even with the best bailout there is nothing that will stop the US from going into a deep recession. As I have said in comments threads on other blogs, the best thing to do at the moment is for individuals to pay off debt and live within their means. Moreover, even with hundreds of billions of dollars (or even more) being hurled at the problem, US economic policy in the medium to long term should be focused upon the points I have reiterated before and yet again remind you:

• Cut military spending
• Raise taxes on the rich
• Run a fiscal surplus to pay off debt
• Use interest rates to keep inflation low
• Re-regulate the financial industry to prevent such a crisis from occurring again
• Fire Ben Bernanke
• Create a universal health care system that will cut present health costs

I still think that a crash in the US dollar is likely and that the coming recession will probably end up rivalling the great depression - and I say this even if a bailout goes ahead. There is nothing anyone can do to reverse the problem, but there is plenty that can be done to limit any future damage.

We told you so (sadly)

Econ bloggers like myself have been saying for years that a big crash was coming. This sort of prediction was not the sort of thing you would find in the deepest, darkest corners of the internet amongst conspiracy theorists and DIY economists - rather, it was the result of study, thinking, logic and discussion.

As a result, we Cassandras (the red headed lady you can see in the picture) have been cursed with the knowledge of the future without the means to convince anyone who mattered.

My own prediction came about in August 2005. In that prediction I spoke about a "perfect storm" (a phrase that was not used as often as it is now of course) which included four main points:

• A housing market crash.
• A US Dollar crash.
• Rising oil prices caused by peak oil.
• Government debt becoming unsustainable.

It would be nice to think that I was the only one saying these things, but credit where it's due - a whole host of doomsayers were discussing these issues before I took them up. But, as far as I know (and this is self-promotion time), I was the only one to put them all together.

And it's annoying because if I had the means I could have made myself quite rich if I had invested enough money into markets I knew would be affected. Back in 2004 when I first understood Peak Oil I was kicking myself with annoyance that I didn't have the means to purchase shares in oil companies that I knew would shoot up as Peak Oil got worse.

And it's annoying also because people in power were totally ignorant of the dangers. Take Ben Bernanke - in July 2007 he was assuring everyone around the world that the subprime bubble was contained. One month later the market tanked and since then the world has been in perpetual economic crisis. Why is it that people like Bernanke get to be in well paid positions of power while Cassandras like myself, who saw the coming storm, get ignored.

As soon as Bernanke dropped rates last year I made the prediction that oil would go beyond $100. In January of this year I predicted that the US would be stagflating. In March this year I even proposed my own version of The Big Bailout^TM that has since become rather important.

The reason why I posting this is that I'm feeling rather cheesed off. I don't like the fact that the world is about to go through the Second Great Depression^TM. I don't like the fact that people are losing jobs and going through emotional and financial stress, leading to marriage breakdowns, suicide and crime. I don't pretend to hope for a utopia but I I unashamedly believe that good policy and foresight can help limit the damage caused by human stupidity.

So there is no schadenfreude, no gleeful shouts of joy over rising bankruptcies, rising unemployment and economic decline amongst us economic Cassandras. Only head shaking and annoyance.

Tax increase plan must follow bailout

Details, details, details.

I'm personally not interested in the finer points of the Paulson bailout plan. Whether it is an undemocratic grab for power or some sort of corporate welfare is really not the issue for me. I reluctantly agree that some sort of bailout is necessary, but I am no real supporter of Paulson and Bernanke, nor the financial system that got itself into this mess in the first place. Without some sort of relief, the US credit system would seize up and, although this is somewhat deserved, the collatoral damage for the rest of the economy would be too high.

So, the bailout is necessary. But I'm not going to stop there. With such a massive amount of debt added to the public accounts, the Federal government will be paying back this debt for years to come. Short term relief? Yes. But long term pain as the government struggles to repay the debt.

WIthout some way of paying for the debt, the only option seems to be tax increases. The bailout plan is just too large, and US government spending is just too (relatively) small for any form of expenditure cutting on behalf of the government - unless, of course, Americans are happy to suddenly give up Social Security or shut down the military.

And the ones who should shoulder these tax increases? Why not the ones who got the US into this mess in the first place? There seems no choice but to increase income taxes on the highest marginal tax rate. The corporate tax rate should also be increased.

Naturally, such proposals would leave some spluttering into their gin and tonics. "Raise taxes?" they say, "What a preposterous thing to suggest! Don't you know that lower tax rates encourage economic growth? If we raise taxes during a recession, we'll be killing the goose that lays the golden egg!".

To which I reply - look at what low corporate taxes and low income taxes have brought about. The popping of the housing bubble and the credit crisis were not caused by horrible, yucky increases in taxation. In fact, the bubble and the credit crisis came about AFTER tax rates were LOWERED.

Others would not just be spluttering into the gin and tonics but also be locking and loading their assault rifles. "The Federal guvmint is just TOO big!", they say "Taxation and government are violence! If the guvmint raises taxes, I'll be shacking up in Idaho!"

To which I reply good riddance. Go to Idaho to protect yourself from the guvmint while the rest of the country suffers under the hand of corporate irresponsibility.

Yes, this is another fine mess you've got us into corporate America and the political shills you have bought and paid for who pass legislation to make you richer.

But back to Paulson and Bernanke. Yeah, congress, give them the money. But raise taxes too. In fact, insist that no bailout plan be passed without Paulson, Bernanke and Bush adding tax increases to the bill.

What if?

One of my great fears is that this current economic crisis will lead to a crash in the value of the US Dollar. This is something I have been predicting since at least 2005 and now seems more certain than ever.

Of course, what prompts me to write this is the recent drop in the US Dollar. Is this the beginning of the end? I honestly don't know. The thing about predicting economic trends the way I do is that the event occurring is more certain than when it occurs. The US Dollar may jump back up to last week's levels in the next 24 hours, but the downward trend is more likely to occur at some point than any time before. It's like geologists making predictions about earthquakes or volcanic eruptions - the signs are all there that it will happen, but the actual time and date is unknown. When it comes to the US Dollar crashing, the same principle is in effect.

So, assuming I am correct, what will happen to America after the Dollar crash?

1. Economic decline - even more.

It's hard to imagine, but the most obvious effect of a currency crash is economic decline. In normal circumstances this would be bad enough, but, if judicious economic and financial analysts are to be believed, America is already facing the worst economic conditions since the Great Depression. The subprime bubble has spread financial contagion all throughout the US. Big companies are going bankrupt, the sharemarket is volatile and unemployment is rising. And that is all happening before a dollar crash.

If and when the dollar crashes, the effects of the crash will reverberate throughout the economy. While the current credit crisis is hitting mainly financial firms while manufacturing and services take some serious collateral damage, a crash in the dollar will heighten these effects. Banks and financial firms that could have been saved from bankruptcy won't be saved. Firms that could've survived battered and bruised will go under. People who would've been able to keep their jobs throughout the original crisis will lose them. A dollar crash will take the damage already done and make it worse.

In terms of official statistics, you can already see GDP reclining. 2008 Q3 will most likely see economic decline when the stats get released in October. Unemployment, already at 6.1%, is likely to increase. But a dollar crash will make these worse. GDP will continue to decline for 2 or more quarters after the dollar crash, and unemployment will continue to rise.

As I have pointed out above, economists and financial analysts see this crisis as being the worst since the Great Depression. This means that unemployment is likely to reach, at the very least, the levels of the early 80s recession - 10.8% in November and December 1982. Now add to this the dollar crash and you can add a few more points to that level. Unemployment of 12% or more is likely.

2. Inflation and the policy problems that follow it.

The most obvious effect of a dollar crash will be a substantial increase in inflation. The United States is a consumer-based economy rather than a producer-based economy. This means that much of America's economic life depends upon the consumption of imported goods. If and when the dollar crashes, the price of all goods and services will increase.

A dollar crash will make imported goods more expensive to import. Americans will therefore find that everything from gasoline to teddy bears will begin to cost more.

Debate still rages over whether this crisis will lead to increased inflation or deflation. The "Deflationistas" - those who believe that prices will drop - argue that a credit crunch of the sort we are experiencing has historically led to deflation, that is, falling price levels. These people are actually correct in a sense, as any economic contraction leads to lower levels of demand for goods and services, which will inevitably lead to downward pressure on prices. Unfortunately, these deflationistas don't take into account something as serious as a crash in the dollar. If the value of the US dollar is ignored in calculations, then deflation is a natural conclusion for those who are studying the current credit crisis. The problem is, though, that recent history - namely the 1997 Asian Economic Crisis and the 1998 Russian economic crisis - shows that any credit crisis in economies with floating currencies (ie, currencies that are traded in the marketplace and change in value accordingly) eventually leads to capital flight - a situation in which people take assets and money out of an economy in order to invest it in another. What happened in 1997 and 1998 was that investors ran from Asia and Russia and invested in the US Dollar.

So, in the midst of the worst financial crisis in over seventy years, a dollar crash would inevitably lead to upward pressure on prices- namely, inflation. What these inflationary levels might become depends upon how far the currency crashes - the more the currency crashes, the higher inflation will get.

In the midst of this situation, what can the government do? Very little I'm afraid. The only government institution charged with the task of controlling inflation is the Federal Reserve Bank. Faced with a dollar crash and spiralling inflation, what would the Fed do? Standard monetary policy is for central banks to raise interest rates to control inflation. In the past, the Federal Reserve has indeed lifted rates whenever inflation began to worry them.

The problem with raising interest rates is that, while it ends up controlling inflation, it also acts to dampen economic activity. If the Federal Reserve should raise rates in response to inflation brought about by the dollar crash, the effect upon an already deteriorating economy would be devastating. Yet to keep rates low and to endure inflation in the hope that the economy might be given a chance to recover is a process which has historically never worked - the 1970s, for example, saw central banks all over the world ignore inflation and focus on employment and economic growth. Despite this, neither the economy nor levels of employment nor inflation were ever fixed. It was only until Paul Volcker bit the bullet and killed off inflation with high interest rates in the early 1980s that inflation, economic growth and employment ended up getting fixed. In other words, the only way for central banks to improve economic conditions and levels of employment is to focus solely upon inflation. In our particular situation, with a potential dollar crash looming, the only thing the Federal Reserve Bank could do in response is to raise rates.

I need to reiterate: There is nothing that the President, Congress or the Federal Reserve Bank can do to solve this problem. The only thing they can do is to limit the damage and remove the policies that caused the problem in the first place. As I have mentioned before, the only thing that the Government can do is:

• Cut military spending
• Raise taxes on the rich
• Run a budget surplus and pay off public debt
• Use interest rates to keep inflation low
• Regulate the financial industry with more common sense laws
• Fire Ben Bernanke
  

As I said, none of these things will solve the crisis, but they will give a better grounding for the eventual economic recovery.

I would also add to this list the following:

• Institute a Universal Health Care system, and raise taxes to pay for it.
  

I don't put this here just because I'm a pinko commie subversive, but because it also makes economic sense. The United States of America could cut its total health care costs by one third if it instituted a Universal Health Care system similar to those already in operation in other Western nations. The US spends around 15% of GDP on health care while comparable Western nations spend around 10% of GDP and have the same - if not better - health outcomes. Cutting health care costs by deprivatising and regulating the health industry will have enormous social and economic benefits.

3. A Current Account Surplus as America recovers.

Although I often joke that a dollar crash will be "financial armageddon", I know that things will eventually turn around. Even the great depression ended, although those who suffered through it thought it might never end. The same is true in this case. The current crisis added to a dollar crash will cause some very serious economic damage, but a recovery will naturally follow (although the speed of this recovery might not be as fast as people hope).

One thing that will happen as America - and the world - recovers from an economic disaster and dollar crash is that the US will eventually become a net exporter. Moreover, the United States will eventually end up running a current account surplus. This will be the natural effect of a dollar crash.

If and when the US Dollar crashes, one result will be that American goods and services - even manufactured goods - will become more competitive on the world market. While the dollar crash will naturally hurt every part of the economy, international demand from US manufacturing will increase. America's economic recovery will be in many ways due to an increase in demand for American goods. Instead of being a consumer nation, the US will become a producer nation after the dollar crash.

Moreover, it is also likely that the world's producer nations - especially those who have run massive trade surpluses like Japan and China - will end up becoming consumer nations. This will be because the dollar crash will end up overturning current trade balances. It may seem strange to believe that Japanese consumers might end up buying US manufactured goods, but, if a dollar crash occurs then the natural corollary will be a rise in the value of the Yen and other world currencies. When a currency rises, imported goods become cheaper to buy and exported goods become more expensive to sell.

4. A New International Economic Order.

One eventual result of this crisis will be a new economic world order. I'm not talking conspiracy theories or a one world government here, I'm talking about a more integrated world economy in which trading nations agree to abide by treaties that will determine what sort of policies are implemented in national economies.

Such treaties already exist. Supranational entities like the United Nations, the World Bank, the International Monetary Fund and the World Trade Organisation all exist as a way of creating and developing international co-operation in economic areas. An even more advanced supranational entity - the European Union - has even greater power over how member countries may run their affairs.

For anyone who insists upon national sovereignty, such entities are despicable and evil. For those of us who know just how important common rules and policies are for international economic well-being, such entities are exceptionally important (although certainly not perfect).

The importance of any future economic agreement rests upon the damage done at present. Although the US is a sovereign nation and its economic downturn is entirely its own fault, the damage that it will create will spread around the globe. No nation linked in with the world economy will escape damage, although it is clear that the US will be the nation most badly affected. Given that this is the case - that one nation's economic stupidity can lead to economic pain for all nations - economic treaties and agreements will be put in place to ensure that all nations who participate in the world economy follow "the rules" to prevent their own contagion from affecting everyone else. One aspect of this agreement may be common monetary policy, whereby central banks will pursue the same goals, such as having common inflation targets. Another agreement may be universal rules applied to financial sectors, which would not only prevent economic problems in one nation, but in all nations who are part of the treaty. In America's case, accounting principles would be better suited following international rules rather than the homegrown American ones.

Conclusion

For some, a dollar crash will lead to financial armageddon. But, just like in the Great Depression, the United States and the rest of the world will recover and learn from the mistakes that were made. Unemployment may sky-rocket and the economy may decline, but they will both recover eventually.

Unfortunately I'm not as confident as I could be at this point. Peak Oil will make it very difficult for economies to recover over the next 10-20 years, while Global Warming won't stop just because humans have had some economic problems. Both of these issues will require much thought and changes in economic and social behaviour - changes which will cost but which are necessary if people's lives are to be saved. Moreover, the economic and social challenges posed by both Peak Oil and Global Warming need a workable economy to be faced.

It's time to follow The Washington Consensus

I've just finished scanning my way through The Washington Consensus. Until now I didn't realise how much neoliberal economic theory I had imbibed over the years, which is supremely ironic considering my support for big government ideas like universal health care, free public education and industry regulation - essential components of Democratic Socialism.

The Washington Consensus was, according to Wikipedia:

initially coined in 1989 by John Williamson to describe a set of ten specific economic policy prescriptions that he considered to constitute a "standard" reform package promoted for crisis-wracked developing countries by Washington, D.C-based institutions such as the International Monetary Fund (IMF), World Bank and the U.S. Treasury Department.

And here were the ten policy prescriptions (again, copied and pasted from Wikipedia):

• Fiscal policy discipline.
• Redirection of public spending from subsidies ("especially indiscriminate subsidies") toward broad-based provision of key pro-growth, pro-poor services like primary education, primary health care and infrastructure investment;
• Tax reform – broadening the tax base and adopting moderate marginal tax rates;
• Interest rates that are market determined and positive (but moderate) in real terms;
• Competitive exchange rates;
• Trade liberalization – liberalization of imports, with particular emphasis on elimination of quantitative restrictions (licensing, etc.); any trade protection to be provided by low and relatively uniform tariffs;
• Liberalization of inward foreign direct investment;
• Privatization of state enterprises;
• Deregulation – abolition of regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions;
• Legal security for property rights.

Now compare that list to the list of policy decisions I have been proposing as a way of mitigating America's current economic plight:

• Cut military spending
• Raise taxes on the rich
• Run a fiscal surplus to pay back public debt
• Use monetary policy to keep inflation low
• Create and enforce stricter financial regulation so this doesn't happen again
• Fire Ben Bernanke
  

Who would've thought about prescribing for America what America prescribed for developing economies under financial stress?

If you check out the points of The Washington Consensus, there are many points which apply.

Fiscal Policy Discipline.
This pretty much fits in with my "cut military spending, raise taxes on the rich and run a surplus to pay back debt". The important thing here is that fiscal policy - how a government spends its money - should be disciplined. In other words, there should never be any large amounts of public debt. As I have pointed out multiple times before, America's public debt is too high as it is and will go even higher in the aftermath of this current financial crisis. Had the US government under Bush been fiscally disciplined, the level of public debt would have been a lot smaller, and the cost of bailouts and fiscal stimuli been more sustainable. Moreover, neither the US government nor the market can spend its way out of the current financial crisis. Spending more will make it worse. Austerity is needed.

Redirection of public spending from subsidies toward broad-based provision of key pro-growth, pro-poor services.

I haven't really touched on this because the US doesn't have much in the way of subsidies except for the mind-blowingly stupid agricultural subsidies and protection in place. What has occurred, however, is a "subsidy" in the form of tax cuts for the rich. In other words, the cutting of taxes for the rich since 2001 might as well be the same as government subsidies for certain industries. These tax cuts were certainly not enjoyed by the poor, whose plight is shown up by median wage data which shows wages in 2008 to be below that of 2001. Moreover, according to The Washington Consensus, "pro-growth, pro-poor services" are things like increased spending on health care and basic education - two areas which have suffered in America's recent history.

Tax reform – broadening the tax base and adopting moderate marginal tax rates.

Tax should be simple and should be broad. Taxing one industry more than another leads to an economic imbalance. Again, this part of the Consensus can be applied to the Bush tax cuts because such tax cuts ended up narrowing the tax base. Moreover, by decreasing taxes for the rich, more money than normal would have been pumped into investments. The current financial crisis has seen this money disappear.

Interest rates that are market determined and positive (but moderate) in real terms.

As I have argued elsewhere on this blog, the Federal Reserve ran negative real interest rates from 2003-2005, and from mid-2007 onwards. This has occurred under the chairmanships of both Alan Greenspan and Ben Bernanke.

John Williamson, one of the main proponents of The Washington Consensus, writes that positive real interest rates "discourage capital flight" and "increase savings". Capital flight is now a real danger to the US economy, a process which would lead to a severe devaluation of the US dollar.

Privatization of state enterprises.

Fannie and Freddie - need I say more?

Deregulation.

This is obviously and interesting one. Some people think that this would involve cutting away government rules and letting the market go haywire - in other words, what has been occurring recently. Yet such deregulation in The Washington Consensus is qualified - only regulation which will result in better economic performance should be set up. This naturally includes instances where unregulated markets end up destroying themselves and the wealth of others. In the case of America's financial market, better rules and regulations should be set up to prevent this crisis from occurring again.

...

In summary, I submit again that the only policy direction the US should go in now is to follow the points of The Washington Consensus that they themselves helped to create. Moreover, I submit again that there is no other choice. The crisis has hit, the seeds that were sown are now being reaped. Watching the Treasury and the Fed act like incompetent third-world officials making panic-stricken, knee-jerk decisions is more than enough evidence for anyone who looks at this issue judiciously.

A new financial order needed?

Reuters:

Threatened by a "financial tsunami," the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.

The commentary in the overseas edition of the People's Daily said the collapse of Lehman Brothers Holdings Inc (LEH.P: Quote, Profile, Research, Stock Buzz) "may augur an even larger impending global 'financial tsunami'."

The People's Daily is the official newspaper of China's ruling Communist Party, and the overseas edition is a smaller circulation offshoot of the main paper.

Its pronouncements do not necessarily directly reflect leadership views, but this commentary by a professor at Shanghai's Tongji University suggested considerable official alarm at the strains buckling world financial markets.

China's central bank earlier this week cut its lending rate for the first time in six years, a move analysts said was aimed at bolstering the economy and the battered stock market.

"The eruption of the U.S. sub-prime crisis has exposed massive loopholes in the United States' financial oversight and supervision," writes the commentator, Shi Jianxun.

"The world urgently needs to create a diversified currency and financial system and fair and just financial order that is not dependent on the United States."

Kenneth Rogoff:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

If this crisis goes any further and deeper, the chances of a run on the dollar intensify. The US Dollar's recent rise in value has been swift, especially when compared to its long term devaluation over the past year: The value of the Dollar dropped around 10% between August 2007 and the middle of March 2008 (source), a process which was accompanied by a rise in the price of oil and increasing levels of inflation.

There are reasons why the US Dollar is likely to fall.

The first is that interest rates in the US are so low that any overseas investors buying government bonds are unlikely to see a decent return. Interest rates are higher in the Eurozone, Australia and other places in the world.

The second is that, with the sharemarkets tanking in the US, overseas investors are unlikely to want to keep up direct investments in US companies. Put simply, the US is a toxic place to invest and international investors are likely to sell their US shares and then retreat from the US entirely.

Thirdly, the US economy, by running a current account deficit for such a long time, is geared towards borrowing and consumption. A recession will cause domestic consumption to drop, resulting in an eventual rebalancing of the current account - a process which will make US dollars less valuable for investors to hold.

I can assure you beyond any doubt whatsoever that any panicked sell-off of the US Dollar would be the last thing the US needs. This credit crunch is packing some serious damage already. Add to that inflationary pressures of a tanking currency and there will be a stagflationary period the likes of which America has never seen before.

The only real way to prevent the dollar from falling - and the only way to save it once a fall begins - is for the Fed to increase interest rates. Raising rates during a recession may seem counter-intuitive, but I can guarantee you that the alternative, hyperstagflation, would be even worse.

Socialism for the rich - continued

NYT:

Fearing a financial crisis worldwide, the Federal Reserve reversed course on Tuesday and agreed to an $85 billion bailout that would give the government control of the troubled insurance giant American International Group.

The decision, only two weeks after the Treasury took over the federally chartered mortgage finance companies Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank’s history.

With time running out after A.I.G. failed to get a bank loan to avoid bankruptcy, Treasury Secretary Henry M. Paulson Jr. and the Fed chairman Ben S. Bernanke convened a meeting with House and Senate leaders on Capitol Hill about 6:30 p.m. Tuesday to explain the rescue plan.

They emerged just after 7:30 p.m. with Mr. Paulson and Mr. Bernanke looking grim, but with top lawmakers generally expressing support for the plan. But the bailout is likely to prove controversial, because it effectively puts taxpayer money at risk while protecting bad investments made by A.I.G. and other institutions it does business with.

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s role as an enormous provider of financial insurance to investors who bought complex debt securities. That effectively required A.I.G. to cover losses suffered by the buyers in the event the securities defaulted. It meant A.I.G. was potentially on the hook for billions of dollars worth of risky securities that were once considered safe.

If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, which in turn would have reduced their own capital and the value of their own debt.

“It would have been a chain reaction,” said Uwe Reinhardt, a professor of economics at Princeton University. “The spillover effects could have been incredible.”

Okay, now for my "yes but".

I agree. AIG, like Fannie and Freddie, needed to be bailed out. By taking on the financial problems of one organisation, the Federal Reserve can then dilute its negative effects upon the economy. Rather than AIG getting a bullet in the heart, the Fed catches it, breaks it up into little pieces, and then hurls each little piece at taxpayers and businesses - hurting them but not killing them. In a massive financial emergency, such an action will help mitigate the negative effects of one company's distress. It is, in other words, a classic socialist action - the many paying for the pain of one.

Nevertheless, the Fed is playing with fire here. America's entire financial system is based upon free market ideas that sets aside direct government interference in the marketplace and desires less regulation imposed upon them by this government. With the American financial industry partly collapsing, it could be argued that if the government should turn up to mitigate market failure then the government should also be there when things are going well, regulating the industry and profiting from it through tax revenue.

At some point, the money paid by the Fed and the US Treasury for Bear Stearns, Fannie Mae & Freddie Mac and AIG has to be accounted for. Money has to be found to rebalance government coffers.

Of course, both the Fed and the US government share in the blame for the current financial mess. Both Congress and the White House have, since 2001, decided to be fiscally irresponsible and cut taxes during an economic expansion. Moreover, the Fed kept interest rates ridiculously low under Greenspan from 2003-2005 and has created negative real interest rates during that period and also more recently under Bernanke. Negative real interest rates were one of the reasons why an investment bubble formed, and one of the reasons why it has popped so badly.

But let's get real. Were any Wall Street bigwigs warning the Bush government to stop cutting taxes or telling the Fed to raise interest rates? No. It was pressure from the financial markets that dictated America's expansionary fiscal and monetary policy in recent years. While we can certainly find time to blame Bush, Bernanke and Greenspan for kowtowing to the market, we should also find time to blame the financial market itself for promoting such ruinous policies.

Which means that, of course, the financial markets are simply reaping what they sowed. They profited from a bubble, now they are paying for it popping.

Except that they're not - at least not at the moment.

Where is the government going to get the money to pay for their "socialism for the rich"? Will they raise business taxes? Will they increase the top tax rate? It is the rich who created this financial black hole, so why not make them pay for it?

Of course the government could simply increase income taxes on everyone, which will then burden everyone with the problems created by a few. The government could also decide to cut defense expenditure or health expenditure to cope with the increase in debt. They could also just print money if they want to and create a Weimar hyperinflationary event. Or they could just ignore the debt, keep borrowing whatever they need, and then watch the US Dollar eventually crash.

My solution?

• Cut military spending
• Raise taxes on the rich
• Run a fiscal surplus to pay back public debt
• Use monetary policy to keep inflation low
• Create and enforce stricter financial regulation so this doesn't happen again.
• And, of course, fire Bernanke.
  

Robbing people with inflation

Interest rates in the US are now so low, and inflation rates are so high, that anyone who has put their money in an interest bearing account is losing money. This is an intolerable situation as it is essentially robbing people of their hard earned money and punishing them for being fiscally responsible.

According to summary tables from The Economist magazine, America's inflation rate is 5.6%, while the rate on ten year bonds is 3.75%. I'd hate to see what sort of interest rate is being charged on Commercial bank time deposits.

Many, including econ-blogger Mike Shedlock (Mish), are predicting that inflation pressures are short term and that the real long term problem will be a deflationary environment caused by the US subprime crisis.

While I agree that the subprime crisis and the credit crunch that has followed has a deflationary effect, I also believe that high oil prices and a low US Dollar have created an inflationary environment as well. More than that, I believe that the net effect of these crises will end up on the inflationary side of things. Moreover, I can see a stagflationary environment (5% inflation plus 5% unemployment) developing over the course of the year.

I have stated before that the credit crunch and the subprime mortgage crisis that preceded it were the result of lax fiscal and monetary policy in the US. I have written about America's developing fiscal crisis elsewhere, so today it is time for me to write about America's monetary problems.

It is almost a given today that the subprime crisis was caused by excessively low interest rates from 2002 onwards. Here is an important graph from the St Louis Fed:

As you can see, interest rates were reduced dramatically throughout 2001 as Alan Greenspan sought to limit the damage caused by the popping of the tech bubble. As a result, interest rates from 2002 until late 2004 were kept below 2% to stimulate economic growth.

But here is the same graph with inflation added:

As this second graph shows, inflation (the thin red line), exceeded interest rates from late 2002 to the end of 2005 - three years in which people's savings were eroded, three years in which people were punished for not spending the money in their wallet, three years in which people were encouraged to go on a credit splurge.

And it is that period which saw the housing bubble being inflated. Fortunately, growing inflation led the Fed to increase rates - a process that didn't stop runaway house prices until 2006.

To keep this in its historical context, let's look at how inflation and interest rates have performed since 1980:

You can see Volcker's interest rate hikes back there between 1980 and 1982, along with Greenspan's cuts from 1990 to around 1994. You can also see episodes where inflation outperformed interest rates - for a small time in 1980 and a period during 1994 where the rates pretty much matched each other. It has only been the 2002-2006 period that saw a long term period of real negative interest rates, along with post 2008.

It seems reasonably clear from this latter graph that Greenspan's rate cuts after the tech boom went way too far. The early 80s rate cuts and the early 90s rate cuts were far more staggered, while the 2001 cuts were like jumping off a cliff. It could be argued, therefore, that America's monetary policy, post-2001, has been dangerous, imbalanced and, well, incompetent. Not only was inflation allowed to exceed interest rates, but it created a bubble that, when popped, has resulted in yet another period of negative real saving.

In other words, what caused the problem is being used to solve it.

Since we're at a point now where stagflation is again a serious issue, it would be good to examine what real interest rates were during the 1970s, the period we all associate with high inflation and stagnant economic growth. Here is the 1965-1980 graph that matches the same information on the graph above:

So not only were there negative real interest rates between mid 1974 and 1978, but the 1978-1980 rates barely rose above zero. This period of history was punctuated by repeated recessions, the longest of which - the one caused by Paul Volcker's interest rate hikes - was needed to kill off inflation, a process that led to a very wide spread between inflation and rates and which resulted in reasonably high real interest rates throughout the 1980s.

I would argue that this data essentially proves a general relationship between recessions and negative real interest rates. Along with the 1954-1974 figures (which you can see here), there appears to be a causal relationship between the two. Moreover, the data also seems to suggest that whenever real interest rates are positive, and when these real rates are wide, the gap between recessions lengthens. This is not always true though, and my assertion is very much a generalisation because other factors come into play that are not taken into account in the graphs above.

Nevertheless I will point out that America's experience of negative real interest rates from 2002 to 2005 and from 2008 to today is very unusual. Moreover, Bernanke's interest rate cuts in late 2007 and early 2008 came at a time when inflation increased sharply. Since the Fed often acts to anticipate events, it could be argued that they were expecting inflation to fall sharply in 2008, something which has not occurred.

The US economy has only diced with negative real rates five times since 1954: 1957-1958, 1974-1980, 1994, 2002-2005 and 2008 (the last one is ongoing). The fact that the last two have occurred so quickly is what is so unusual.

Let me explain again what the problem with negative interest rates are: They punish people for saving while rewarding them for spending; they punish people for lending and reward people for borrowing; they punish people who are judicious and reward those who are careless. In short, negative real interest rates are a recipe for economic disaster.

This, in turn, is one reason why I have argued for years that central banks, including the Fed, should focus clearly on reducing inflation. Employment, which is of vital importance to society, and businesses, who make the decision to employ people, both need economic growth. But economic growth, to be sustainable over the long term, needs to have low inflation and positive real interest rates.

Balance is the key here. There is nothing wrong with spending just as there is nothing wrong with saving; there is nothing wrong with lending and nothing wrong with borrowing. Negative real interest rates, however, produce a severe imbalance in that area.

Update:
Serendipitously, Mish has just posted an article entitled "Real Interest Rates are High".