Friday, October 24, 2008

Depression logic pushes fast cash into the economy

Anna Schwartz co-wrote with Milton Friedman the signature piece of work on money and economic stability.  Now 92 and still working, she recalls that in 2002, now US Fed chairman Ben Bernanke said in a speech in honour of Friedman's 90th birthday:  "I would like to say to Milton and Anna:  Regarding the Great Depression.  You're right, we did it.  We're very sorry.  But thanks to you, we won't do it again."

In fact, the hubris of those in charge of policy intervention is never having to say sorry -- at least for their own actions.  Bernanke, and before him Alan Greenspan as well as Australia's Reserve Bank chiefs Glenn Stevens and Ian MacFarlane, knew the history of the Great Depression inside out.  With that knowledge they are certain they could have stopped the present unwinding of global markets.

And yet, and yet!

The prologue to the current crisis was the same effervescent money supply expansion we saw in the 1920s.  Easy and cheap money caused the same asset price inflation.  Uncertainty over how long this could last and belated attempts by the authorities to rein it in led to the Great Depression.  Central bankers then and now oversaw a shovelling out of money into the economy.  In doing so they were sowing the seeds of disaster.

The recent period of debt accumulation fuelling asset inflation is instructive.  For Australian households, debt to disposable income increased from under 40% in the mid-1980s to over 150% by the mid-2000s.  Although asset values also rose, this still left a huge rise in debt net of assets.  And the value of assets (especially houses and shares) that underpinned most of that debt is now heading south.

Interest rates were held too low for too long and a level of housing stock that zoning regulations have kept in tight supply was the obvious outlet for the Reserve Bank's monetary excesses.  Households' interest payments on homes, historically at less than 4% of disposable income, ballooned out to double this by 2004 and, with the interest rate increases since then, in June of this year approached 12%.

As with the Great Depression, governments are now "reinflating".  In doing so, they are taking the advice of the very reserve banks and treasury departments that furnished the advice and pulled the levers that caused the problem.  Governments and reserve banks are lowering interest rates, handing out cash and supporting financial businesses with suspect assets.

Treasury secretary Ken Henry's Senate testimony appears to affirm that he and the RBA were of one mind in supporting blanket guarantees to bank deposits, a measure that fails to recognise the knock-on effects on other saving vehicles the positions of which are worsened as a result.  We need a scalpel, not a sledgehammer.

Simply reducing interest rates does not solve the problem, which is that assets are overvalued -- and some financial businesses that have highly leveraged loans are holding some assets that are worthless.

Nor are cash handouts or other such measures in the Government's $10.4 billion program a solution.  As ever, the problem is not a shortage of demand.  It is that people have become overextended and, with assets overvalued, they have to repair their real levels of savings.

Disposing of the budget surplus in a spending spree means releasing funds that previously were locked up in forced savings by taxpayers.

If pushing $10.4 billion into the economy to promote consumer spending was going to do the trick why not increase the largesse tenfold?  There is no documented case of handouts averting a recession.  Unless the productive potential is there, more money will not bring increased output.  And Australia's productive potential has been diminished in recent years by wasteful investments and by regulatory impediments.

While we should release funds that have been taken from the community in over-taxation, we must simultaneously remove many other inflexibilities that have diverted savings from productive venues.  Above all, we must recognise that assets are not worth as much as we thought they were.  Having done so, we have to allow asset prices to fall to their underlying market value.


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