Tuesday, August 26, 2008

Recent Central Banking Errors

The Wall Street Journal carried an article last Saturday written by 'breakingviews.com,' the outfit that occasionally targets a good topic with substandard analysis, entitled "Honest Central Bankers..."

According to the crew at the tiny research outfit, the world's influential central bankers committed three mistakes in the recent past:

1. Failure to consider the "dangers of financial deregulation."
2. Excessive pride in managing "steady economic expansion and moderate inflation, but we should have been humble about wild asset-price inflation."
3. They were "remiss in not considering the distortions created by an annual US trade deficit the size of the Dutch economy."

I continue to be mystified as to why, with their equity interest in breakingviews.com going to zero, the Journal still publishes these lightweight pieces on the valuable top-left of the back page of the paper's Money & Investing section.

That said, the topic is worthwhile. Looking back over the past 12-14 months, we see the greatest dysfunction in credit markets at least since the late 1990s sovereign reneging on debt by Russia and the LTCM mess.

How much of this recent- and continuing- debacle is really the fault of the two major central banks, the American Fed and the EU's central bank?

If central bankers made mistakes, I don't actually think they were the three identified by breakingviews' analysts.

Once a nation decides to allow substantial private monetization of future valuation potential, the central bank isn't really in control of the supply of liquidity or even 'money,' in its practical meaning, anymore.

When private enterprises can routinely issue large amounts of bonds, similar to what occurs in a Fed open market action, they pump up money supply totally out of the control of the Fed. There's a reason the old 1950s-era credit controls were in place. But having moved beyond that era, we really cannot now return.

The Fed and the EU central bank don't really control asset-price inflation, nor can they, except, for example, by some slight regulatory oversight to at least assure the creation of high-quality mortgage assets, instead of low- or no-down payment mortgages.

Thus, mistakes one and two aren't, in my opinion, valid accusations of central banks in this era.

Alleged mistake number three is also incorrect. Ricardian economics assumes all participants are doing something of value. Exchange rates take care of the imbalances of trade flows.

What, exactly, do the geniuses at breakingviews suggest the central banks should have done to affect commercial trade flows between nations and currencies? Return to old-style, fixed or pegged exchange rates?

Once again, this is a non-issue for central banks.

The one thing I believe of which the central bankers were and are guilty is simple misperception of the consistency and non-normalcy of the drivers of recent inflation- energy and commodities- as Brian Wesbury pointed out in a Wall Street Journal editorial about which I wrote, here. There was another fine editorial covering some of the same ground in the past week in the Journal, although I have forgotten who were its authors. Essentially, they correctly accused Greenspan of freely spending the credibility Paul Volcker had bought for the Fed with his effective breaking of inflation in the late 1970s and early 1980s, in concert with Ronal Reagan's equally-effective fiscal discipline.

Largely due to Alan Greenspan, we now see, the Fed began to unwisely pump money supply in the early 2000s, leading to today's inflation. While there are other monetizers besides the central banks in our modern economy, when the central banks inflate, it still causes inflation.

Between Greenspan's cavalier dissipation of the Fed's inflation-fighting credentials of the Volcker era, and Bernanke's political timidity last year in keeping rates high while using the Fed's discount window to assure liquidity to the collapsing financial fixed-income sector, the US central bank has all but lost its ability to convince holders of dollars that they will not be robbed of value by inflation.

Would it really have been so hard for Bernanke and his colleagues to see recent energy and other commodities price rises as the results of growing demand in economically-maturing India and China for these products in the face of poor demand forecasting by their producers?

That inflation measures including food and energy were valid because what was occurring was not seasonal or occasional price volatility, but a secular, if temporary, upward trend due to forces of supply and demand?

I honestly thought that Bernanke was smarter than he has appeared to be in the past year. Adding his indecision to the results of Greenspan's egotism have given us an inflation rate heading to heights we haven't seen since Reagan took office.

Funny, isn't it, how both US economics and political choices seem to both stand at crossroads last faced when the Gipper- and Tall Paul- were there to help our country make wise choices.

Sadly, too few Americans are of an age who recall this.

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