Responding to crises.

• Jurisdiction: United States
• Date: 22 March 2007
• Author: Frankel, Jeffrey
• Published date: 22 March 2007
• Author: Frankel, Jeffrey

They say "there are no atheists in foxholes." Perhaps, then, there are also no libertarians in crises. Even those in favor of sharply reducing the role of the government usually agree that, for example, there is a valid lender of last resort role for the central bank in the event of banking panics or disruptions as occurred on September 11, 2001. (1) But crises should not become an excuse for public policy that is hasty or ill-informed, or that serves primarily the interests of the policymakers themselves or of special interests. The response must be appropriate and careful. It must be informed by the longer-term perspective offered in the lessons of historical precedent, particularly regarding the fallibility of well-intentioned government intervention, and by an awareness of the dangers identified in the theory of moral hazard.

There are many different kinds of economic crises, not all of them strictly financial. I will organize my discussion around the following list: inflation crises, stock market crashes, bond market crashes, housing crashes, and various international crises, including the possibilities of a hard landing for the dollar, emerging market crises, oil shock, geopolitical crisis, and trade collapse. In light of the importance of the longer-term lessons to be drawn from historical precedent, I will draw heavily on U.S. examples from the last four decades. Those who forget history are condemned to listen to the rest of us repeating George Santayana.

Inflation Crises

A prime lesson of the last four decades is that monetary policy needs to be proactive with respect to inflation. The Fed should respond to an observed increase in inflation by raising the nominal interest rate more than one-for-one--unless it was a predicted increase in inflation, in which case the Fed should already have done so (Poole 2002).

The classic crisis in the value of the dollar came in the 1970s. President Johnson in the 1960s increased spending rapidly on both the war in Vietnam and domestic programs, and was initially unwilling to raise taxes to pay for it--a pattern of which the most recent six years have been reminiscent. The resulting budget deficits were accommodated by easy monetary policy and led to rising inflation, a declining trade balance, and a widening deficit in the overall balance of payments. The situation continued under President Nixon, and came to a head with the devaluations of the dollar in 1971 and 1973. Arthur Burns gunned the money supply in 1972, evidently in order to ensure the president's re-election, while wage-price controls-supposedly anathema to conservatives (2)--kept inflation temporarily under control. Of course inflation soon re-emerged more virulent than ever. In 1979, facing a crisis in the value of the dollar in terms of both goods and foreign currency, President Jimmy Carter appointed Paul Volcker chairman, with the assignment of tightening monetary policy severely--supposedly anathema to liberals--in order to defeat inflation. Volcker duly accomplished the job.

Ronald Reagan took office in 1981 and adopted another strongly expansionary fiscal policy. The supply-siders did not get the consequent boost to saving, investment, and growth that they had been expecting. They blamed it on the Volcker Fed and its overly tight monetary policy. Bob Woodward's book Maestro documents how the Reagan-Bush administrations pushed the Fed chairmen to lower interest rates, especially in election years (Woodward 2000:16-17 for 1984; 52-54 for 1988; and 78-82 for 1991-92). (3) But the campaign did not succeed very well. (4) The Reagan White House tried in 1986 to load the Fed Board with "easy money types," who would outvote Volcker and lower interest rates (Woodward 2000: 18-20). But before long they acquired the culture of the institution, and in the end took their jobs seriously, in what I call the Thomas h Becket syndrome. The White House did succeed in making life unpleasant enough for Volcker that he asked not to be reappointed, prompting James Baker to exult "We got the son of a bitch!" (Woodward 2000: 24). But the successor, another hand-picked Republican, once again surprised the White House by doing the right thing. Chairman Alan Greenspan raised interest rates, far enough to cause the 1987 stock market crash and the 1990-91 recession, thereby costing President George H. W. Bush re-election in 1992. At least that is the way the Bush people saw it (Woodward 2000: 196).

The Greenspan Fed probably erred by providing too much liquidity in 2001-2004. I await Woodward's customary follow-up book, where we learn whether those who entered the White House in 2001 took Greenspan aside, raised 10-year-old grievances, and applied some heavy arm-twisting. This hypothesis is pure speculation, with no evidence behind it. It has the advantage of being able to explain the extraordinarily easy monetary policy of 2001-04. (5) It could also explain the chairman's warning in January 2001 congressional testimony that future budget surpluses would be too big for effective monetary operations unless something were done about it, a statement that the chairman's previous wisdom and rectitude rendered otherwise inexplicable. But then perhaps Karl Rove and Vice President Richard Cheney, and their boss President George W. Bush, are true gentlemen who would not engage in the same sort of bare-knuckles tactics countenanced by the elder Bush or Ronald Reagan.

If the Fed erred in keeping interest rates so low so long after the 2001 recession, what cost are we paying? None yet, but dangers lie in the future. It is not that I am especially worried about inflation at the moment. Inflation has been low over the last decade. The core CPI inflation may bump up against 3 percent, but a return of the high inflation rates of the past is not at the top of my list of worries, in part because I trust the Bernanke Fed to respond appropriately. (6)

If not inflation, what cost do I fear might come from the extraordinarily easy monetary policy of 2001-04? As the Bank for International Settlements points out, some of the biggest financial crashes and some of the longest recession periods have followed liquidity-fed booms that never did show up as goods inflation, but rather as asset inflation: the 1920s boom which ended in the 1929 crash and the Great Depression of the 1930s, Japan's late-1980s boom that ended in an analogous stock and land market crash and decade of stagnation in the 1990s, and the East Asian boom that ended in the crises of 1997-98.

So let us turn from inflation crises to the possibility of securities market crashes and other possible crises. These dangers could be interpreted as disruptive corrections that might arise in the future from excess liquidity and excessive asset inflation during the first half of this decade.

Securities Market Crises

As of the date of writing, stock market prices are again unusually high. The possibility of a sudden correction goes on the list of potential crises. The obvious U.S. precedents are the stock market crashes of 1987 and 2000-01. In both cases Greenspan responded with a sudden easing of liquidity. This led to a belief among market investors that they could relax in the face of a high stock market because they held a "Greenspan put." The obvious danger of such a belief is moral hazard. Better to seek to...