Part of the problem is central bankers, past and present. They are working overtime to avoid assuming any blame for creating crisis. Their twisted talks are like military history. Recall that military history is written by victors. Economic history is written, to a degree, by central bankers. In both cases you have to take the official version with a large grain of salt.
Doctored accounts often gain wide circulation in the sphere of economics, too. Unfortunately, false beliefs are very difficult to overturn by facts, and fallacies play a significant role in economic policy discourse.
For a prime exhibit of this type of dissembling, we have to look no further than former chairman of the Federal Reserve Alan Greenspan’s article in the March 11 issue of The Wall Street Journal: “The Fed Didn’t Cause the Housing Bubble.” That title vividly tells Greenspan’s story. But does it withstand scrutiny?
Under Greenspan and current chairman Ben Bernanke, the Fed has embraced the view that stability in the economy and stability in prices are mutually consistent.
As long as inflation remains at or below its target level, the Fed’s modus operandi is to panic at the sight of real or perceived economic trouble and provide emergency relief. It does this by pushing interest rates below where the market would have set them. With interest rates artificially low, consumers reduce savings in favour of consumption, and entrepreneurs increase their rates of investment spending.
Then we have an imbalance between savings and investment. We have an economy on an unsustainable growth path.
This, in a nutshell, is the lesson of the Austrian critique of central banking developed in the 1920s and 1930s. Austrian economists warned that price-level stability might be inconsistent with economic stability.
They placed great stress on the fact that the price level, as typically measured, extends only to goods and services. Asset prices are excluded. (The Fed’s core measure for consumer prices, of course, doesn’t even include all goods and services.)
The Austrians concluded that monetary stability should include a dimension extending to asset prices and that changes in relative prices of various groups of goods, services and assets are of utmost importance.
For the Austrians, a stable economy might be consistent with a monetary policy that has prices falling gently. The current U.S. financial crisis follows the classic Fed pattern. In November, 2002, then-governor Ben Bernanke set off a warning siren that deflation was threatening the U.S. economy. He convinced his Fed colleagues of the danger.
As former chairman Alan Greenspan put it then, “we face new challenges in maintaining price stability, specifically to prevent inflation from falling too low.” (Given the U.S. economy’s productivity boom, the Austrians viewed the prospects of some deflation as just what the doctor ordered.)
In the face of possible deflation, the Fed panicked. By July, 2003, the Fed funds rate was at a new record low of 1%, where it stayed for a year. This set off the mother of all modern liquidity cycles and, as members of the Austrian school anticipated, this credit boom ended badly.
Until central bankers admit that their misguided policies were the primary cause of the current boom-bust cycle, the crisis will continue to be misdiagnosed. And the prescriptions including more fiscal stimulus packages, the expansion of the scope and scale of government regulations and an upward ratcheting of the International Monetary Fund’s lending will continue to burden the economy.
A confession by the central bankers would pull the rug out from all these misguided prescriptions.
