[PEN-L:28434] RE: The D word surfaces

["Devine, James" <jdevine@xxxxxxx>]

Title: RE: The D word surfaces

I wrote:
> >I quoted Epstein & Ferguson to the effect that monetary policy
> >hadn't been applied because of bank influence, agreeing with what
> >you say below. On the other hand, Doug was saying that it was
> >applied -- since the discount rate fell a lot -- but didn't work. As
> >far as I'm concerned, both can be true: I don't think monetary
> >policy works well at all in situations like 1929-32 or 2001-?.

Doug writes:
> I don't think it's a controversial point that the Fed didn't try hard
> enough from 1929-32 - but a 75% decline in the discount rate ain't
> chopped liver, either. The stock market failed to respond to that 75%
> decline, and the decline in market interest rates, because a
> deflationary collapse was underway, and, as JD says, monetary policy
> can't do much about those (though the Fed could probably have
> mitigated the damage had they been more aggressive). The failure of
> the stock market to revive in the face of much more aggressive Fed
> easing today is pretty scary, given the 1930-31 precedent; it
> suggests, though certainly not conclusively, that some kind of
> deflationary unraveling is underway. And since big government makes
> total collapse unlikely, it seems likely that some version of Japan
> in the 90s is happening in the U.S. economy today.

To a large extent, the effects of the Fed's rate cuts have shifted away from the stock market over to the housing market. The big question is whether or not there's a bubble in the latter market. If so, the US is definitely "turning Japanese."

> I'm not convinced by Ferguson-style explanations of the Fed's
> inaction; it could be that central bankers of 70 years ago just
> didn't know what they were doing. Why has the Fed eased so
> aggressively in this cycle? Is bank influence lessened, or do central
> bankers know just how risky it is not to ease in the face of
> financial implosion? The Fed is clearly taking the Japan precedent
> very seriously, and they were much quicker to ease than the Bank of
> Japan was 12 years ago.

Ignorance is always part of the story of policy, though with any luck there's less of it now. In 1929, the "conventional wisdom" concerning recessions was that they should be allowed to take their course, because they would lead to purgation of imbalances, which would in turn allow renewed growth. That view has largely faded, producing the late 1990s view that the Maestro could use the Federal Funds rate to fine-tune the economy, an equally ignorant view (to my mind). (It's faded until recently when the late 90s bubble --> imbalances --> recession view, a revival of imbalances theory, has become increasingly popular, in fact being endorsed by Dubya.) It's quite possible, however, that the Fed folks are much more knowledgeable than in 1929. Now, for example, they know that a financial crisis can have very large spread effects (as in the 1930s, as in Japan). They learned from experience, I hope, that "letting nature take its course" can be totally disastrous.

There have been some major political changes, though, that encourage AG to "wake up and smell the coffee." I think that there's a larger coalition in favor of keeping stock prices and the economy from falling, since stock ownership crept down the social pyramid a bit. More importantly, the "institutions" (such as the California public pension plan) have a lot of political influence.  During the "bubble years," individuals, companies, and governments acted based on the economic and political assumption  that the stock market wouldn't fall and the economy wouldn't collapse. This is a crucial reason behind the explosion of private-sector debt and large state spending plans (at least in California). When those assumptions fail, the consequences are dire. So there's a lot of political pressure that says "something must be done."

Jim