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Financial Times: Central Banks Need to Force a Recession

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adrock3215

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I saw this article in the Financial Times by Wolfgang Münchau over the weekend and thought it was interesting. Since it requires a free signup to read, I would post the entire article; however, since it is against forum rules I will post some parts from it that I felt were interesting and highlighted the central premise of the article:

So who are they? I recall a wonderful episode told by Jagdish Bhagwati in his book In Defense of Globalization when he quoted John Kenneth Galbraith as saying: “Milton’s [Friedman’s] misfortune is that his policies have been tried.”

As I have been saying for some time now, Friedman has been the most destructive force in economics within the last half century. His supposed 'defense of laissez-faire' on positivist grounds has hurt more than helped wherever it has been accepted.

Several of them [economists] have been leading proponents of an economic theory known as New Keynesianism. It is, in fact, probably the most influential macroeconomic theory of our time. At the heart of the New Keynesian doctrine stands the so-called dynamic stochastic general equilibrium model, nowadays the main analytical tool of central banks all over the world. In this model, money and credit play no direct role. Nor does a financial market. The model’s technical features ensure that financial markets have no economic consequences in the long run.

This model has significant policy implications. One of them is that central banks can safely ignore monetary aggregates and credit. They should also ignore asset prices and deal only with the economic consequences of an asset price bust. They should also ignore headline inflation. An important aspect of these models is the concept of staggered prices – which says that most goods prices do not adjust continuously but at discrete intervals. This idea lies at the heart of some central bankers’ focus on core inflation – an inflation index that excludes volatile items such as food and oil. There is now a lively debate – to put it mildly – about whether an economic model in denial of a financial market can still be useful in the 21st century.

Hmmmm...

So when economists tell us that we need to keep real interest rates negative, just as we did for long periods in the past 15 years, or that we now need to bail out homeowners and banks and raise our national debt in the process, or ignore any considerations of moral hazard while the crisis is raging, we might want to question whether the recipes that got us into this mess are also most suited to get us out again.

Münchau ends the article by proposing some policy decisions. Some of them include new regulations, and he also advocates letting defaulting major banks go bust, but his main point is that a recession may be needed to avoid a disaster of tremendous proportion, such as a depression. Basically, in his view, a cold shower is needed to wake up the patient, and policymakers should recognize this. His recomendation is that monetary policy should be changed immediately by raising interest rates significantly, which I agree is probably the best thing central bankers can do immediately, right now under a fiat monetary system. He ends with:

We might run a greater risk of a recession in the short term. But a recession is not the worst possible outcome. The worst is for this crisis to go on and on, for Minsky’s moment to become an eternity.
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Why?

I'm not sure if you were asking my opinion or Münchau's so I will try to provide both, to the best of my ability.

Münchau's reasoning is that cheap money and credit is what brought about the current downturn. He concludes that a reversal of policy is necessary. This means, in practice, that when inflationary expections and pressures are high, real interest rates should be at the least positive. I suppose he is taking the point-of-view that managing price stability is the only proper function of a central bank.

In my estimation, if I was to take a stand on what should be done by central bankers within the context of today's system, I would tend to agree with Münchau. This means, assuming there is such a thing as a central bank (I don't agree with the legitimacy of such a system at all), then it seems to be a fact that a sole interest in price stability is "the best of the evils", so to speak. This fundamentally clashes with the Fed's dual mandate, which is at least partially responsible for Bernanke's recent decisions. Contrast the Fed's actions with the ECB's actions, and you can see the difference in practice. The ECB hiked rates last week while the Fed seems to remain tied to easy money, despite inflationary pressure.

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Münchau's reasoning is that cheap money and credit is what brought about the current downturn.

Well, this is what my "Why?" pertained to. Why do low interest rates cause an economic downturn? I am not aware of any theory that says this; in fact, nearly all theories say the opposite. And didn't we have high interest rates before the crisis began? The rates have been cut now, sure, but that was a reaction to a recession that had already begun.

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Well, this is what my "Why?" pertained to. Why do low interest rates cause an economic downturn? I am not aware of any theory that says this; in fact, nearly all theories say the opposite. And didn't we have high interest rates before the crisis began? The rates have been cut now, sure, but that was a reaction to a recession that had already begun.

The only school I am aware of that thinks along similiar lines is the Austrian School with the Austrian Business Cycle Theory. In essentials, it states that the business cycle is caused by governmental manipulation of money and credit. Which means that low interest rates lead to a boom during which capital is misallocated. This leads to a bust when economic actors realize capital is actually scarce and it is subsequently reallocated towards more efficient uses.

We did not have high interest rates before the crisis began. Greenspan kept real interest rates for overnight loans between banks (Fed Funds) negative for an extended period of time (during the period from 2004-2005 short-term nominal rates were set at 1% for nearly a year). From 2002-2005 the nominal rate was under 2%, which is of course negative in real terms.

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We did not have high interest rates before the crisis began.

Yes we did, starting from 2006. The Fed was just beginning to hike rates when Salsman wrote that article; they kept raising rates for the next year or so and the yield curve got severely inverted--causing the current recession.

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Yes we did, starting from 2006. The Fed was just beginning to hike rates when Salsman wrote that article; they kept raising rates for the next year or so and the yield curve got severely inverted--causing the current recession.

Inverted yield curves do not 'cause' a recession; they do, however, predict a recession. Salsman's article confirms this.

Either way, a discussion of this particular only serves to ignore the main issue. Remember that the Fed was raising rates in response to inflationary overheating, which was occuring because of the loose monetary policy of roughly 9/11/2001 to 2005. Such loose monetary policy caused the inevitable capital malinvestment (subprime mortgages would be one of these, another would be the explosion of leveraged buyouts by private equity firms) that is now being corrected.

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Could you define and elaborate on this "inflationary overheating" please? What do you think would have happened if the Fed had not raised rates?

Let's start over. Assume we both know about Austrian economics and agree with their Business Cycle Theory.

Now: What exactly is your major issue in this thread? With full knowledge of the Austrian Business Cycle, are you maintaining that the loose monetary policy of post-9/11 times and the corresponding boom did not cause the current bust?

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Most articles I've seen point to the financial crisis beginning with the actions of hte FED coming out of the internet bubble in 2002.

adrock, based upon CF's comments I'd say he doesn't buy into the Austrian school of Business Cycle.

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adrock, based upon CF's comments I'd say he doesn't buy into the Austrian school of Business Cycle.

It's to be expected.

The Austrian Business Cycle basically says when we have all this cheap credit, people will go out and expand on it; normal consumers will buy things like houses or cars, and business will make huge investments. This large amount of spending will trigger the Fed to make an Open Market Sell and decrease the monetary base, thus getting rid of all that cheap money and causing a subsequent bust.

We see this going on with the housing sector today. There was a boom of cheap credit, people bought things they couldn't afford and now they are in trouble.

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Let's start over. Assume we both know about Austrian economics and agree with their Business Cycle Theory.

Now: What exactly is your major issue in this thread? With full knowledge of the Austrian Business Cycle, are you maintaining that the loose monetary policy of post-9/11 times and the corresponding boom did not cause the current bust?

Well, I suppose if you accept the Austrian cycle theory, then having permanently high interest rates IS the logical thing to do. Sort of works as a nice reductio ad absurdum of the theory, if you ask me...

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Well, I suppose if you accept the Austrian cycle theory, then having permanently high interest rates IS the logical thing to do. Sort of works as a nice reductio ad absurdum of the theory, if you ask me...

I am a bit confused. Do you not accept the essentials of the Austrian Business Cycle?

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I am a bit confused. Do you not accept the essentials of the Austrian Business Cycle?

I am still struggling to understand the exact meaning of the theory, but from what I've read of it, I am not convinced. I have some very fundamental-level disagreements with the Austrian school (most notably, with their idea that all values are subjective), and I also disagree with the Keynesian idea that an economic boom necessarily means inflation--which seems to be an integral part of the Austrian Business Cycle theory.

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