Federal Reserve | timiacono.com - Part 55

In Defense of Larry Summers

There’s a lot not to like about Larry Summers, but something positive emerged last week.

As you no doubt already know, along with current Federal Reserve Vice Chair Janet Yellen, Summers is one of the two leading candidates to be the next Federal Reserve Chairman and, as such, his views on Fed money printing and the lack of aggregate demand as the proximate cause of our economic woes found in this Financial Times story($) should make things pretty interesting were he to actually get the job.

First, on “quantitative easing”:

“QE in my view is less efficacious for the real economy than most people suppose,” said Mr Summers according to an official summary of his remarks at a conference organised in Santa Monica by Drobny Global, obtained by the Financial Times.

And, perhaps more importantly, on an economy’s “potential” output:

Larry SummersIn his remarks in April, Mr Summers said it was likely either the economy would accelerate, or else estimates of its growth potential would have to come down.

“If we have slow growth, we are not going to keep thinking that 5.5 per cent unemployment is normal,” said Mr Summers. “We are going to decide rightly or wrongly that the potential of the economy is less and therefore we are going to decide that we are closer to that potential and that is going to operate in favour of suggesting that we should normalise interest rates.”

You don’t hear this sort of talk from anyone other Austrian economists and, to PhD economists in the U.S., it’s about as close to blasphemy as you can get.

With the tenure of Fed Chief Ben Bernanke almost surely ending in about six months, between now and then, we are likely to hear lots of retrospectives on the job that he’s done and Floyd Norris gets the ball rolling in this New York Times article that features none other than Australian economic Steve Keen who, along with a few others, saw what was coming.

It is amazing that a lot of criticism of the Federal Reserve today focuses on what it clearly got right — the response to the debt crisis in 2008 and thereafter, a response that may well have prevented Great Depression II — and not on what it got wrong: policies that allowed the dangerous imbalances to grow and bring on the crisis.

Steve KeenWhen I talked to Mr. Keen this week, he called my attention to the fact that Mr. Bernanke, in his 2000 book “Essays on the Great Depression,” briefly mentioned, and dismissed, both Minsky and Charles Kindleberger, author of the classic “Manias, Panics and Crashes.”

They had, Mr. Bernanke wrote, “argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior.” In a footnote, he added, “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.”

The current period is not unlike the Great Depression in that, for most economists, all the bad stuff started in 2007-2008, rather than in the years leading up to the crisis. Most of the Bernanke legacy talk will center on the post-2008 period and that’s a real shame because central bank policy was instrumental in creating the mess that Bernanke inherited.

One need look no further than the 2006-era thinking that financial innovation in the form of subprime lending, etc. was really Technology-Driven Wealth Creation.

Here’s a rather disturbing parallel between monetary policy today and in the 1970s via a Wall Street Journal op-ed ($) by John Taylor, Stanford University economics professor and former Treasury undersecretary for international affairs.

A growing number of economists, former central bankers and senior government officials—including Martin Feldstein, Paul Volcker, Allan Meltzer, Raghu Rajan, David Malpass and Peter Fisher—have now concluded that the Fed’s policies are not working. Critics want the Fed to return to a more rules-based monetary policy.

John TaylorMeanwhile, the global monetary system is starting to fracture. Central bankers around the world, especially in emerging markets such as Brazil, India and South Africa, have experienced adverse spillovers of Fed policy on their currencies and economies. To prevent sharp fluctuations in the value of their currencies and volatile inflows and outflows of capital, they have had to deviate from good policy.

With so many voices rising in objection, some might assume that it will be just a short time until the Fed changes course. Unfortunately, this assumption is unwarranted based on the experience of the late 1960s and 1970s.

In 1968, Milton Friedman explained the folly of the view that permanently lower unemployment could be achieved through easier monetary policy. At first, his view was adopted by a small minority. By the mid-1970s, there was consensus that easy money was not achieving its economic growth or employment goals.

Then the argument shifted to “yes, we agree that the policy is not working, but it is too costly to end.” The economy was performing adequately; shutting the money spigot would just make things worse. Yet unemployment and inflation only increased.

It was not until Paul Volcker became chairman of the Federal Reserve in August 1979 that the Fed’s excessively easy monetary policy came to an end.

My guess is that economists at Stanford and Cal (e.g., Reich, DeLong) don’t often get together to compare notes about what the Fed is or should be doing.

Sometimes it seems we might all be better off if current Federal Reserve Chairman Ben Bernanke were more like former Fed Chief Alan Greenspan.

BernankeRecall that traders and investors were often left scratching their heads after listening to what Greenspan had to say and, as some suspected back then, the disgraced former Fed Chief really didn’t know himself what he was trying to communicate much of the time. Markets were left to figure things out on their own and they did a pretty decent job of it, that is, up until the central bank inflated one too many asset bubbles about a decade ago.

Ben Bernanke, on the other hand, has taken great pains to improve the Fed’s communication strategy. It seemed to be working right up until May when the subject of “tapering” their $85 billion per month money printing effort became central to the discussion.

Since then it’s been an unmitigated disaster in many areas, the notable exception being U.S. stocks, as markets have been roiled by hawkish talk followed by dovish comments. The latest example of this came yesterday when Bernanke unwittingly boosted the price of most assets, notably gold that has now seen its sharpest move higher in two months, though the Fed Chairman didn’t really say anything new.

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Lawyer/economist/investment banker Jim Rickards shares a few thoughts on the Federal Reserve, global currencies, and the price of gold with Bob English at Russia Today.

I don’t know about you, but I sure miss Lauren Lyster on RT Capital Account. She’s over at Yahoo! Finance these days doing the Daily Ticker where, apparently, things are going well.

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