Thursday, September 16, 2010

The Centre Cannot Hold - By Michael Lewitt

Years of misguided fiscal and monetary policies led to the 2008 financial crisis. Now a refusal to shed these discredited policies and embrace creative and politically bold solutions is keeping our economy mired in high levels of structural unemployment and below-trend growth. In addition to the bugaboos of efficient markets and investor rationality that have led policymakers and investors astray for so many years, we can add a misguided faith in Keynesian solutions to debt crises, a near-religious belief that mild deflation must be avoided at all costs, and uninformed media hype about the alleged benefits of mergers and acquisitions to the list of bad ideas that continue to lead economic policy and markets astray. As David Rosenberg, who has been far more prescient than most about the direction of the economy in recent years, has written, those who missed the current economic relapse “live in the ‘old paradigm’ world of recoveries occurring in the context of a secular credit expansion and they have not updated their models to the realities of a secular credit contraction.”

The evidence is clear that normal monetary and fiscal transmission mechanisms have broken down. And it is not simply a matter of poor execution, although the stimulus bills and mortgage remediation plans promulgated by the government were hardly paragons of efficiency or efficacy. It appears that the U.S. and global economies have reached the tipping point beyond which the majority of money creation takes place outside the control of governments and central banks. This condition should not apply in a true crisis situation in which non-governmental actors pull in their horns and government agents are empowered by panicked politicians to pull out all of the stops and literally flood the financial system with funds. In non-crisis times, however, the market should be willing and able to fund itself.

Unfortunately, due to the failure of policymakers to adopt the proper policies to stimulate growth (as well as the noxious anti-growth rhetoric and legislation promoted by the Obama administration), non-governmental economic actors (i.e. corporations and consumers) are again refusing to spend. As a result, the system has been seized by a massive paradox of thrift that is more akin to what one would expect in a crisis or near-crisis scenario. Policymakers learned the wrong lesson from Keynes. Rather than continued debt-financed government spending, they should have focused on this paradox of thrift that arises when corporations and businesses lose faith in leadership. Trying to cure a debt crisis with mountains of debt that will ultimately have to monetized is enough to make anybody stuff their cash in the mattress and start building bunkers in their back yards.

Comparisons with the Great Depression are useful as far as they go, but they may not go as far as necessary to get us out of our current morass. The 21st century world and its economies are profoundly different from the early 20th century one that suffered a calamitous economic collapse. For one thing, there were leaders that people believed in; perhaps new ones will emerge now to replace the imposters who are currently in office. But the key to studying history’s lessons is not simply looking for similarities between the past and present, but drawing the proper distinctions that can lead mankind to improve his current course of action. The current approach to solving our economic ills has been driven by a near religious fear of even mild deflation, and has taken the form of a purely Keynesian brew of government spending and artificially low interest rates that penalize savers. While Keynesian stimulus was needed at the height of the crisis, maintaining this approach once markets and the economy have stabilized is a recipe for years of below trend growth and extension of the boom and bust cycle that has characterized the last three decades of the U.S. economy. The Obama administration’s economic team learned the wrong lessons from Keynes and from history.