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Monetarism Fiasko

Monetarism enters bankruptcy procedding

End times for Milton Friedman - THE WEEK

After World War II, laissez-faire economists had a big intellectual problem: the Great Depression. How could you argue for dismantling the post-WW II social insurance states and returning to the small-government laissez-faire of the past when that past contained the Great Depression? Some argued that the real problem was that the laissez of the past had not been faire enough: that everyone since Lord Salisbury and William McKinley had been too pinko and too interventionist, and thus the Great Depression was in no way the fault of believers in the free-market economy. This was not terribly convincing. So advocates of a smaller government sector needed another, more convincing argument.

It was provided by Milton Friedman.

Friedman proposed that with one minor, technocratic adjustment a largely unregulated free-market would work just fine. That adjustment? The government had to control the "money supply" and keep it growing at a steady, constant rate--no matter what. Since money was what people used to pay for their spending, a smoothly-growing money supply meant a smoothly-growing flow of spending and, hence, no depressions, Great or otherwise. In Friedman's view, if the task of monetary stabilization could be accomplished via technocratic manipulations by a non-political central bank, there would be no need for much of the apparatus of the post-World War II social insurance state.

In the 1950s Friedman's doctrines were considered way out there. But his Keynesian adversaries overreached, and claimed that clever governments could maintain price stability and a high-pressure economy with "full" (rather than merely "normal") employment. By the 1970s, it was clear they were wrong. Since then, advocates of expanded social democracy have been on the retreat more often than on the advance. By the 1990s, even left-of-center politicians had come to respect central bankers' mastery of the money supply, giving them a wide berth.

The power of Friedman’s theory was, in part, rhetorical. "Keep the money supply growing smoothly" sounds like it means to keep the presses in the Bureau of Engraving and Printing rolling at a constant pace, printing out a steady flow of pictures of George Washington. But that is not how "money supply" actually works. In economic reality, "money supply" means not just cash money but also credit entries the Federal Reserve has made in commercial banks' accounts at the Fed; plus all the credit entries commercial banks have made in households' and businesses' checking accounts; plus savings account balances; plus (usually) money market mutual-fund balances; plus (sometimes) trade credit and the ceilings between credit card limits and consumers' current balances.

No central banker controls all these vast and varied sluices of the money supply – at least not in economic reality. When banks and businesses and households get scared and cautious and feel poor, they take steps to shrink the economic reality that is the "money supply." Businesses extend less trade credit. Credit card companies cut off cards and reduce ceilings. Banks call in loans and then take no steps to replace the deposits extinguished by the loan pay-downs. Without a single bureaucrat making a single decision to slow down a single printing press, the money supply shrinks—disastrously in episodes like the Great Depression. Thus in emergencies, to say that all the central bank has to do is to keep the money supply growing smoothly is very like saying that all the captain of the Titanic has to do is to keep the deck of the ship level.

For the past eighteen months the collective central banks of the world have been trying as hard as they can to keep the deck of the ship level. Traditionally, central banks boost the money supply by buying government bonds from the Treasury for cash. Buying government bonds for cash cuts the supply of bonds the private sector can acquire, boosting their price while lowering interest rates, making businesses more eager to spend to expand and making asset holders feel richer and thus more eager to spend to consume.

The central banks and finance ministries of the world have purchased so many government bonds for cash that they have pushed the prices of short-term government bonds up as high as they can possibly go. With interest rates practically zero, there is no extra interest return to be gained in the short run from bonds. Yet it has not been enough.

So increasingly over the past year, the central ministries of the globe have taken extra measures: they have guaranteed debts, they have partially or completely nationalized banks, they have forced weak institutions to merge with stronger ones, they have expanded their balance sheets to an extraordinary extent. And yet this, too, has not been enough.

So now the central bankers have thrown up their hands, and asked for help to stimulate spending through tax cuts and government expenditures. Because they have run out of means to "keep the money supply growing smoothly."

Today, we have reached the end of the line for the Chicago view of financial deregulation. Friedman thought (a) that the central bank could exercise enough influence over the money supply to effectively control it, and (b) that banks and other financial intermediaries would be regulated tightly enough that what is now happening would be impossible. But he never resolved the tension between his view that banks need controls and the Chicago view that business must be unfettered.

Monetarism may well make a comeback -- as a doctrine that is good enough for normal times. For in normal times "keep the money supply growing smoothly" does appear to be a relatively easy task, a minor adjustment to laissez-faire that can be performed by a small number of qualified technocrats. Unfortunately, not all times are normal.

- BRAD DELONG is a professor in the Department of Economics at U.C. Berkeley; chair of its Political Economy major; a research associate at the National Bureau of Economic Research; and from 1993 to 1995 he worked for the U.S. Treasury as a deputy assistant secretary for economic policy. He has written on, among other topics, the evolution and functioning of the U.S. and other nations' stock markets, the course and determinants of long-run economic growth, the making of economic policy, the changing nature of the American business cycle, and the history of economic thought.

Monetarism enters bankruptcy By Henry C K Liu

The invasive dominance of monetarism in macroeconomics has been total ever since central bankers, led by Alan Greenspan, who from 1987 to 2006 was chairman of the Board of Governors of US Federal Reserve - the head of the global central banking snake by virtue of dollar hegemony - embraced the counterfactual conclusion of Milton Friedman that monetarist measures by the central bank can perpetuate the boom phase of the business cycle indefinitely, banishing the bust phase from finance capitalism altogether.

Going beyond Friedman, Greenspan asserted that a good central bank could perform a monetary miracle simply by adding liquidity to maintain a booming financial market by easing at the slightest hint of market correction. This ignored the fundamental law of finance that if liquidity is exploited to manipulated excess debt as phantom equity on a global scale, liquidity can act as a flammable agent to turn a simple localized credit crunch into a systemic fire storm.

Ben Bernanke, Greenspan's successor at the Fed since February 1, 2006, also believes that a "good" central banker can make all the difference in banishing depressions forever, arguing on record in 2000 that, as Friedman claimed, the 1929 stock market crash could have been avoided if the Fed had not dropped the monetary ball. That belief had been a doctrinal prerequisite for any candidate up for consideration for the post of top central banker by President George W Bush. Yet all the Greenspan era proved was that mainstream monetary economists have been reading the same books and buying the same counterfactual conclusion. Friedman's "Only money matters" turned out to be a very dangerous slogan.

Both Greenspan and Bernanke had been seduced by the convenience of easy money and fell into an addiction to it by forgetting that, even according to Friedman, the role of central banking is to maintain the value of money to ensure steady, sustainable economic growth, and to moderate cycles of boom and bust by avoiding destructively big swings in money supply. Friedman called for a steady increase of the money supply at an annual rate of 3% to achieve a non-accelerating inflation rate of unemployment (NAIRU) as a solution to stagflation, when inflation itself causes high unemployment.

Stagflation is a de facto invalidation of the Phillips Curve, which shows a negative correlation between the rate of unemployment and the rate of inflation. There is of course irrefutable logic within the workings of a capitalistic labor market in support of the concept of structural unemployment. Yet the conceptual flaw in NAIRU is its acceptance of a natural rate of unemployment as a justification to abandon the social goal of full employment. When unemployment of 6% of willing workers is accepted as structural in an economic system, the fault is with the system, just as if a hospital accepts an annual mortality rate of 6% of its curable patients as structural, the hospital's operation needs to be reexamined. The fundamental flaw in market capitalism is its inherent failure to deliver full employment as a social goal.

Monetary easing should only be tolerated in times of real systemic financial distress in the economy. It should never be administered as a convenient anesthetic to forestall market corrections. Instead, Greenspan in his 18 years at the Fed repeatedly treated every cyclical market downturn as a potential systemic crisis that justified massive liquidity injection by the central bank, only to create larger and larger serial price bubbles as new phantom cycles of growth to defy financial gravity.

Yet while the laws of finance can sometimes be violated with delayed penalty, they cannot be permanently overturned. The fact remains that central banks cannot repeatedly use easy money to fund serial economic bubbles without cumulative consequence. Undetectable debt can be disguised by structured finance as phantom equity, but it remains as liabilities at the end of the day. Risk can be spread globally system-wide but it cannot be eliminated. The result will be a global financial meltdown when this massive Ponzi scheme on the part of central banks is finally exposed.

Greenspan, by his cavalier application of massive liquidity to sustain phantom serial monetary booms, has driven the narrow validity of monetarism into policy bankruptcy. Bernanke, by his blind faith in the power of misguided monetarist measures to deal with a global credit crisis created by decades of runaway monetary indulgence, has unwittingly neutralized even the antibiotic power of Keynesian fiscal countermeasures against demand deficiency in a monetary bust from excessive debt. Deficit financing in a recession does not work without a reservoir of fiscal surplus from a previous boom.

The Fed under Greenspan and Bernanke violated the basic rules of both monetarism (money supply management) and Keynesianism (demand management). Fed monetary policy created false prosperity with excess money supply to fund debt manipulation and simultaneously to support income disparity as a source for capital formation to exacerbate overcapacity amid demand weakness.

Illusory economic growth
The Greenspan Fed repeatedly provided easy money on a massive scale to fund serial asset-price bubbles that were passed off as economic growth. Deregulated finance globalization endorsed enthusiastically by Greenspan led to wide income disparity in the entire global economy. Thus income in every economy eventually failed to support rising asset prices pushed up by debt to unsustainable levels. This forced the excess phantom capital in the global economy to seek growth from manipulation of debt collateralized by a price bubble that was destined to collapse from inadequate cash flow.

Structured finance allows general risk in all debts to be unbundled into tranches in a hierarchy of credit rating, allowing even the most conservative to participate in the debt bubble by holding the supposing safe low-risk tranches. But the safety of these low-risk tranches is merely derived from an expected low default rate of the riskier tranches. As the default rate of the high-risk tranches rises, the safety of the supposedly low-risk tranches vanishes. With runaway "supply-side" voodoo economics keeping wage income in check during the boom phase in corporate profits, the resultant overcapacity from demand lag resulting from low wages shuts off investment opportunities for productive expansion and forces the excess money supply into speculative manipulation of debt, giving birth to restructured finance and sophisticated, circular hedging of risk.

A decade of excess money produced a credit overcapacity, which was solved by a systemic under-pricing of risk and a lowering of credit standards for so-called subprime borrowers. While subprime mortgages were at first mostly a housing sector problem, the derivative effects of the subprime failure quickly infested the entire global financial system. The interconnected factors that fueled the spectacular process of serial bubble formation at an unprecedented rate and on an unprecedented scale to support the false claim of neoliberal finance capitalism as the most effective and efficient economic system in history turned out to be the same factors that brought the entire global capitalist financial system built on debt crashing down in July 2007.

Since Greenspan left the Fed in 2006, a year before the global crash, when mainstream analysts were still praising him as a god-sent savior of debt-propelled finance capitalism, it was left to Bernanke to continue the Greenspan magic and keep the good times rolling perpetually. Not unexpectedly, when the liquidity-fed debt tsunami hit the financial sector in July 2007, Bernanke confidently assumed that the Greenspan "put" would again save the financial system from another collapse of the latest of Greenspan's serial bubbles.

When pressed by Congresswoman Rosa DeLauro (D-Conn) during a hearing whether the economy was in a recession, Bernanke dismissed the question with the professorial hubris reserved for a college freshman that "recession" is only a technical description of economic conditions. "Whether it's called a recession or not is of no consequence," declared the former Princeton professor. Still, as there was even at the time general consensus that market confidence had emerged as a major issue, whether a slowdown is classified officially as a recession has serious consequences in market attitude.

Bernanke's arrogant brush-off to a perfectly valid commonsense question from a concerned legislator presumed to be unwashed in economics theory showed how disconnected the elitist high priest central banker was to earthly reality.

Confident, complacent and wrong
Bernanke was complacently confident he could stop the wave of massive financial destruction caused by decades of abuse of liquidity excess by again adding more liquidity through massive creation of new money. The Fed under Bernanke, instead of saving the economy from the cancer of debt, actually continues to be part of the problem by feeding the spreading cancer. (See US government throws oil on fire, Asia Times Online, October 23, 2008.)

Eight years earlier, Bernanke had declared his faith in aggressive monetarism when he wrote in the September/October 2000 Issue of Foreign Policy an article entitled "A Crash Course for Central Bankers":

A collapse in US stock prices certainly would cause a lot of white knuckles on Wall Street. But what effect would it have on the broader US economy? If Wall Street crashes, does Main Street follow? Not necessarily. Consider three famous episodes: the US stock market crash of 1929, Japan's crash of 1990-1991, and the US crash of 1987.

The 1929 US crash and the sharp decline in Japanese stock prices were both followed by decade-long economic slumps in each country. (The Japanese depression, despite much whistling in the dark by the country's policymakers, still lingers.) By contrast, the macroeconomic fallout from the 1987 tumble on Wall Street was minimal. Why the difference?

A closer look reveals that the economic repercussions of a stock market crash depend less on the severity of the crash itself than on the response of economic policymakers, particularly central bankers. After the 1929 crash, the Federal Reserve mistakenly focused its policies on preserving the gold value of the dollar rather than on stabilizing the domestic economy. By raising interest rates to protect the dollar, policymakers contributed to soaring unemployment and severe price deflation. The US central bank only compounded its mistake by failing to counter the collapse of the country's banking system in the early 1930s; bank failures both intensified the monetary squeeze (since bank deposits were liquidated) and sparked a credit crunch that hurt consumers and small firms in particular. Without these policy blunders by the Federal Reserve, there is little reason to believe that the 1929 crash would have been followed by more than a moderate dip in US economic activity.

The downturn following the collapse of Japan's so-called bubble economy of the 1980s was not as severe as the Great Depression. However, in some crucial aspects, Japan in the 1990s was a slow-motion replay of the US experience 60 years earlier. After effectively precipitating the crash in stock and real estate prices through sharp increases in interest rates (in much the same way that the Fed triggered the crash of 1929), the Bank of Japan seemed in no hurry to ease monetary policy and did not cut rates significantly until 1994. As a result, prices in Japan have fallen about 1% annually since 1992.

And much like US officials during the 1930s, Japanese policymakers were unconscionably slow in tackling the severe banking crisis that impaired the economy's ability to function normally.

Central bankers got it right in the United States in 1987 when they avoided deflationary pressures as well as serious trouble in the banking system. In the days immediately following the October 19th crash, Federal Reserve Chairman Alan Greenspan - in office a mere two months - focused his efforts on maintaining financial stability. For instance, he persuaded banks to extend credit to struggling brokerage houses, thus ensuring that the stock exchanges and futures markets would continue operating normally. (US banks, which unlike their Japanese counterparts do not own stock, were never in any serious danger from the crash.) Subsequently, the Fed's attention shifted from financial to macroeconomic stability, with the central bank cutting interest rates to offset any deflationary effects of declining stock prices. Reassured by policymakers' determination to protect the economy, the markets calmed and economic growth resumed with barely a blip.

There's no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the US economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.

Bernanke follows old route
In his 2000 article of faith, Bernanke was openly endorsing the "Greenspan put", the monetary stance from late 1980s on during which, whenever the economy slowed, the Fed would come to its rescue by radically lowering the Fed funds rate target even to the point of negative real yields as measured against inflation, and kept it there until a new boom bubble was solidly formed. The Greenspan put repeatedly pumped liquidity into the market to avert the price correction consequences of speculative excesses that caused the 1987 crash, then the geo-economic consequences of the First Gulf War in 1991, then the contagion effects from the Mexican peso crisis of 1994, then the Asian financial crisis of 1997 and the Russian default that caused the collapse of Long-Term Capital Management in 1998, then the phantom Y2K digital threat, then the bursting of the Internet dot.com bubble in 2000 and then the market panic from the 2001 9/11 terrorist attacks to launch the subprime housing bubble that burst in July 2007.

Accordingly, Bernanke was complacently confident that another application of the Greenspan put could again handle the housing bubble burst in July 2007. He appeared to have no inkling that the economy had been drawn closer each time since 1978 into a perfect storm of structured finance run amok.

On May 17, 2007, three months before the credit crisis broke out, Bernanke said in a speech on the subprime mortgage market at the Federal Reserve Bank of Chicago's 43rd Annual Conference on Bank Structure and Competition:

... given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.

The top US central banker did not see what Greenspan later called "the crisis of a century" coming at him at full speed to hit him in the face in four weeks. Even on August 31, 2007, six weeks after the credit crisis broke out in mid July, Bernake still spoke with surprising calm confidence in a speech on "Housing, Housing Finance, and Monetary Policy", delivered at the Federal  dependent on conditions in short-term money markets, where the central bank operates most directly.

Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past. These results are embodied in the Federal Reserve's large econometric model of the economy, which implies that only about 14% of the overall response of output to monetary policy is now attributable to movements in residential investment, in contrast to the model's estimate of 25% or so under what I have called the New Deal system.

The econometric findings seem consistent with the reduced synchronization of the housing cycle and the business cycle during the present decade. In all but one recession during the period from 1960 to 1999, declines in residential investment accounted for at least 40% of the decline in overall real GDP, and the sole exception - the 1970 recession - was preceded by a substantial decline in housing activity before the official start of the downturn.

In contrast, residential investment boosted overall real GDP growth during the 2001 recession. More recently, the sharp slowdown in housing has been accompanied, at least thus far, by relatively good performance in other sectors. That said, the current episode demonstrates that pronounced housing cycles are not a thing of the past.

My discussion so far has focused primarily on the role of variations in housing finance and residential construction in monetary transmission. But, of course, housing may have indirect effects on economic activity, most notably by influencing consumer spending. With regard to household consumption, perhaps the most significant effect of recent developments in mortgage finance is that home equity, which was once a highly illiquid asset, has become instead quite liquid, the result of the development of home equity lines of credit and the relatively low cost of cash-out refinancing.

Economic theory suggests that the greater liquidity of home equity should allow households to better smooth consumption over time. This smoothing in turn should reduce the dependence of their spending on current income, which, by limiting the power of conventional multiplier effects, should tend to increase macroeconomic stability and reduce the effects of a given change in the short-term interest rate. These inferences are supported by some empirical evidence.

Bernanke was still twiddling his theoretical thumb in the comfort of his institutional bunker while the whole financial world was falling under a credit fire storm. With the awesome data collection capability at his disposal, the Fed chairman's radar apparently totally missed the possibility of systemic collapse of the non-bank credit market on structured finance from chain-reaction effects of rising subprime mortgage default.

Wealth effect reversed
As the housing bubble burst, home equity loans collateralized by inflated home prices were putting most home mortgages under water and an increasingly large number of home equity borrowers in default. The sudden reversal of the wealth effect was about to destroy the global economy, albeit with a time lag, as Bernanke gave his reassuring speech based on faulty economic theory.

Before the credit crisis developed in July 2007, institutional clients of global money center banks had a range of non-bank options to access funds. Such options included the US$1.2 trillion short-term commercial paper market collateralized by solid asset price and cash flow prospects. Interest rates for commercial paper were normally lower than bank credit rates. Borrowers used banks credit mostly as a temporary backup in the unlikely event that a rollover of maturing commercial paper debt faced unforeseen temporary difficulties.

The credit market went into shock when the commercial paper market abruptly and effectively seized and stayed frozen to all borrowers in mid July. Banks suddenly had to rely solely on inter-bank funding to provide promised credit to clients at a time when cash supply was expected to be squeezed by the usual year-end liquidity shortage. Banks all over the world whose costs of borrowing are based on the London interbank offered rate (LIBOR) market found LIBOR jumping to 202 basis points (2.02 percentage points) above US Treasuries in the third quarter of 2007.

Only after the commercial paper seizure hit LIBOR did the Federal Reserve belatedly realize that the credit market was not clearing efficiently. Half of the world's outstanding finance of $150 trillion, which includes financing for derivative trades, is routinely tied to LIBOR rates. The risk of global recession from widespread toxic infection of the entire credit market caused by rising defaults of US subprime loans was creating panic in the market. The Fed and the Treasury, official guardians of a stable financial market, were the last parties to know that a systemic crisis was about to implode and had only hours to act from their offices in New York when government officials were told by the management of major US financial institutions that they would be unable to meet their global obligations when markets opened in Asia.

Again, an injection of liquidity to forestall an imminent financial crisis was administered by the Fed, notwithstanding that the crisis was in essence an insolvency problem of too much debt with insufficient revenue. Illiquidity was merely the outcome, not the cause. Corporate profit, as measured by the US Commerce Department, fell $19.3 billion in the third quarter 2007, as domestic earnings dropped to $41.2 billion. Yet the drag from sagging US sales and huge financial write-downs from credit losses were offset by still robust earnings abroad, amplified by a weakening US dollar.

Operating profits for SP 500 companies fell 2.5% in the third quarter, the first drop in more than five bubble years. Much of the damage was initially concentrated in the financial sector, where operating earnings fell 25%, as banks and brokerage houses suffered losses from subprime mortgages holdings and related investments.

The credit crisis that imploded in July 2007 was not a Black Swan event that could not be predicted. It actually began in late 2006 when inevitable residential subprime defaults that had been warned of by a few lonely analysts' voices years earlier were finally being reported in the general print media and popular TV programs on finance. The general consensus continued to claim the economy to be fundamentally sound. Pundits at the Wall Street Journal, CNBC and Bloomberg told the clueless public to take advantage of buying opportunities as the market headed south.

By the end of the first quarter of 2007, speculative institutional buyers of investment properties at overblown prices began having problem accessing easy credit to close their overpriced deals. Nervous investors in high-yield fixed income debt began redirecting their funds towards risk-free Treasury notes and bills, driving prices up and interest rates down. Balance sheet loans (cash generated from operations) from banks and insurance companies were still available but at far more conservative credit terms and higher rates. Still, mainstream analysts were insisting the sky was not falling.

The pace of securitization, including commercial mortgage-backed securities (CMBS) issuances, slowed moderately during 2006 and 2007 from the fast pace set between 2002 and 2005, especially for high-leverage private sector issuers. The trend was hailed as a successful soft landing by mainstream pundits while in reality any slight loss of upward price momentum is lethal for a debt bubble.

The stock and bond markets reacted to the rising rate of delinquencies among subprime residential borrowers as the housing bubble deflated. Investors lost confidence in even the top-rated tranches of the securitized subprime loans and all asset-backed securities became illiquid. Hedge funds managed by Lehman, Bear Stearns, Merrill Lynch, Goldman Sachs and others that had purchased subprime asset-backed securities (ABS) reported huge losses as their portfolios were marked to market. Globally, off-shore hedge funds and major banks in Germany and France that invested in subprime ABS also reported significant losses. Investors seeking to increase returns had leveraged their ABS holdings which, when applied to a market decline, exponentially drove prices even lower.

 

losses as of the end of 2007. The trough, of which no one had any reliable estimate, remained in the unknown future despite the Federal Reserve's frantic rate reductions, which by December 2008 has reached near zero.

The impact of the subprime defaults had been magnified as firms purchased for a fee slices of these original-rated pools and repackaged the assets a second time, rated them a second time, and later sold them as lower-tiered units at higher yields to investors with a bigger risk appetite. The impact has been global, as most international money center banks have offices in all major financial centers around the world. (See the three-part Pathology of Debt, Asia Times Online, November 27-29, 2007.)

Going forward, the credit crisis will bring down the retail and office real-estate sectors in all economies as a global re-pricing of risk alters the viability of maturing medium-term loans coming due in coming years. From early mid-2004 to mid-2007, real-estate developers, lenders and property owners used a menu of complex financial instruments to gain access to low-cost funds and shift risk off their balance sheets to the investing public. Easy access to credit had driven capitalization rates way down and debt-financed deal volumes up to new record levels every year since 2002. Institutional-grade assets had been priced using exponents in future cash-flow assumptions in an upward-bending positive parabolic curve. It is inescapable that when global credit markets turn sour, the effect is an equally downward-bending negative parabolic curve.

To be fair, Bernanke was in good company among establishment experts of equally unjustified complacency. Brookings Policy Brief Series #164 dated October 2007, three months after the credit crisis imploded, used as headline - "Credit Crisis: The Sky is not Falling". The brief by Anthony Downs, who describes himself on his website as the "World's Leading Authority" on real estate and urban affairs, asserts that " … the facts hardly indicate a credit crisis. As of mid-2007, data show that prices of existing homes are not collapsing. Despite large declines in new home production and existing home sales, home prices are only slightly falling overall but are still rising in many markets. Default rates are rising on subprime mortgages, but these mortgages - which offer loans to borrowers with poor credit at higher interest rates - form a relatively small part of all mortgage originations. About 87 percent of residential mortgages are not subprime loans, according to the Mortgage Bankers Association's delinquency studies. Subprime delinquency rates will most likely rise more in 2008 as mortgages are reset to higher levels as interest-only periods end or adjustable rates are driven upward. Unless the US economy dips dramatically, however, the vast majority of subprime mortgages will be paid. And, because there is no basic shortage of money, investors still have a tremendous amount of financial capital they must put to work somewhere."

However, while this complacent view was widely held in the financial establishment, not everybody was drinking the Cool-Aid. Instead of "tremendous amount of financial capital", the entire financial sector was seriously undercapitalized as distressed debts added up losses. Warnings had been publicly aired months before the credit crisis imploded in July 2007 by a few lonely voices that the subprime mortgage bubble would burst and its effect would spread globally, granted that such warnings had been summarily dismissed by the establishment media. (See Why the sub-prime mortgage bust will spread, Asia Times Online, March 17, 2007.)

Bernanke exposed
By December 2008, 18 months after the credit crisis broke out in July 2007, events have conclusively proved that Bernanke's faith in the magic of the Greenspan put had been misplaced. Decades of misapplication of Friedmanesque monetarism had driven the doctrine into theoretical bankruptcy. Monetarist measures not only fail to revive an economy caught in a global debt tsunami; there is also clear evidence that the liquidity cure devised by Greenspan has eventually run out of ammunition after the serial bubbles got bigger each time to paper over the previous one. The Greenspan put does not work for a stalled economy facing a liquidity trap of absolute preference for cash. It only adds more water to a raging flood of debt to threaten even the shrinking remaining high ground.

The flaw in his faith in self-regulating monetarism that Greenspan openly confessed before Congress apparently did not get through to Bernanke, who continues to apply the Greenspan put. Bernanke's futile monetary moves to save wayward financial institutions have managed only to increase the immunity of the deeply wounded economy against any Keynesian fiscal cure attempted by the next occupant of the White House and his economic team.

Bernanke made the same mistake of obstinate denial in the early phases of the economic meltdown from a debt crisis even after his acceptance eight years earlier of Friedman's counterfactual conclusion that the Fed in 1930 failed to act in time to respond effectively to the oncoming disaster with bold monetary countermeasures. Again, the world missed another opportunity to test if preemptive Keynesian fiscal cures would work.

More fundamentally, president Herbert Clark Hoover (1929–1933) should have applied Keynesian demand management through fiscal spending to maintain full employment immediately after the 1929 crash, if not before, rather than a timely monetary cure as proposed by Friedman in hindsight. No recovery from speculative excess can be expected without a policy-induced rise in employment and wage income to catch up with an asset price bubble. It was true in 1929; and it is true today.

Unfortunately, the rescue approach by the George W Bush administration led by Treasury Secretary Henry Paulson and the Bernanke Fed has been focused on saving distressed financial institutions by providing taxpayers' money to restructuring bad debts and de-leveraging overblown balance sheets. This approach inevitably pushes already stagnant wage income further down, with more layoffs and ruthless renegotiation of already draconian labor contracts, to cut operating cost. All this does is to reinforce the downward market spiral by transferring financial pain to innocent workers while not helping the economy with a needed revival of consumer demand.

Trillions of dollars of good taxpayer money are being thrown after bad debts concocted by unprincipled financiers into a crisis black hole. This money will have to be repaid in coming years by taxpayers while supply-siders are clamoring for tax cuts for corporations, on capital gains and for high-income earners. This means the future tax bill to pay for the Greenspan put will be borne by low- and middle-income wage earners. Thus far in this financial crisis, the Bernanke Fed has sown the seeds not for a quick recovery but for a decade or more of stagflation for the US and the global economy.

NEXT: Central banking practices monetarism at the expense of the economy

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

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