Catch the Swamp Fever!

As we await another monetary policy proclamation from the Board of Governors of the Federal Reserve System, we take note of another Keynesian economist ruminating on the Austrian view of all things monetary, as a priest might occasionally wonder about the existence of God.

In Paul McCulley's July commentary at Pimco, he ponders the big question that nearly all Keynesians are beginning to ask after Alan Greenspan and other central bankers around the world have been blowing bubbles for the last couple decades, "When does maldistribution of investment catch up with you?"

But, before we get to Mr. McCulley the title of today's post must first be explained. Swamp fever, or more correctly, "fever-swamp Austrians" was a phrase first noticed here after one Stephen Kirchner responded to the widespread objections to the Fed announcement back in November that they would no longer report the M3 monetary aggregate.

In the memorable Repos and Eurodollars in Stealth Mode post from last year, Mr. Kirchner put it thusly:

As Barry (Ritholtz) notes, this is the sort of thing that excites the tin foil hat brigade and fever-swamp Austrians, but I would suggest that there is a rather innocent explanation. Growth rates in broad money and credit aggregates tend to be dominated by trends in financial intermediation and thus have only a very tenuous relationship with monetary policy and even a somewhat loose relationship with economic activity.

Translation - money supply doesn't matter to the makers of monetary policy, so money supply just doesn't matter. It's not important how much money has been created, what's important is what shows up in consumer prices.

Despite protestations such as this, the swamp fever does seem to be spreading, and more Keynesians are catching it. In this story last month, an anonymous economist at The Economist notes that maybe narrowly defined price stability isn't everything - that maybe those Austrians knew a thing or two about rampant credit creation resulting in imbalances even though prices were level.

There are two reasons for dusting off Austrian economics. Financial liberalisation, by allowing bigger increases in credit than in the past, has increased the risk of boom-bust cycles of the Austrian sort. Second, competition from China and faster productivity growth may have changed the inflation process and made traditional indicators a less useful guide to monetary policy.

Defenders of today's monetary-policy method, focused on consumer-price inflation, may say that it seems to have delivered the goods, in the form of more stable growth. So why change? One reason, suggests Mr White, is that if monetary policy is concerned solely with price stability, surges in credit will be restrained only if they trigger inflationary pressures. Ever-bigger financial imbalances could thus build up. Even if inflation remains subdued in the short term, low interest rates could either increase the risk of higher inflation in future or pump up borrowing and asset prices. Should these imbalances eventually correct themselves, there will be a sharp slowdown.

And of course the Mr. White mentioned above is this blog's new favorite economist, Mr. William White at the Bank of International Settlements who published the fine working paper Is Price Stability Enough? (.pdf), and seems to have a rather advanced case of the fever.

The literature produced by the Austrian school of economics in the interwar period concluded that the Keynesian focus on aggregate measures in the economy, like the overall measure of inflation, provided an inadequate bellwether for identifying emerging macroeconomic problems.

Rather, the Austrians focused on the impact of changes in relative prices leading to resource misallocations and subsequent economic crises.
...
While many have rightly criticised the specifics of Austrian capital theory, the concept of erroneous investment processes driven by credit creation is still noteworthy. Moreover, while most Keynesian models assume a relatively smooth adjustment from one equilibrium to another, the Austrians stressed growing imbalances (cumulative deviations away from equilibrium) and an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it.

Yikes!

That's not the way people want to remember Alan Greenspan, the master bubble blower of the last two decades - "growing imbalances and an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it".

It's a good thing we have a Keynesian economy and not an Austrian economy, or we might be in for some trouble.

And that brings us back to Mr. McCulley at Pimco, who noted Mr. White's writing and felt the need to weigh in.

Bill Gross teases me that I’m not just a Keynesian, but a religious Keynesian. There is an element of truth to that, as evidenced by the fact that the only major piece of art that I own is a portrait of Keynes by Salisbury, the preeminent portrait artist of Keynes’ time. And it hangs in my office, presumably watching over me. So, Bill does have a point.

As a practical matter, however, I also have deep appreciation for other schools of economic thought. And, yes, that includes the Austrian School. Indeed, there is much overlap between Keynesian thought and Austrian thought, even though many think they are antithetical lines of thinking.

I was reminded of this recently when reading a brilliant essay by William White, of the Bank for International Settlements – Is Price Stability Enough? Mr. White’s core thesis is that low and stable inflation in goods and services prices, presumably the holy grail of central banking, is not a guarantee of steady growth in real economic activity.

He then goes on to talk about Phillps Rules and Taylors Curves, or maybe it's Ruler Tails and Curvey Fills, but in the end, he gets about the business that has been an increasingly popular passtime with economists today - hedging their Keynesian bets by acknowledging what Austrians have to say about credit excess and asset bubbles.

Yes, I am a Keynesian. But more precisely, I’m a Keynesian wearing Minsky clothing, and doffing Austrian shoes. In the fullness of time, I expect Chairman Bernanke, a brilliant Keynesian, to rediscover that the Austrians were not all wet in their diagnosis of the potential for maldistribution of investment, even though they were soaking wet about what to do about it. The Austrians said let the asset price and credit excesses purge themselves. A much better way, I believe, is to lean against the excesses preemptively, using all available tools, including regulatory tools.

Yes, inflation targeting is fine. Myopic inflation targeting is not. Asset prices matter, and not just in the context of their influence on aggregate demand relative to aggregate supply and, thus, inflation. Asset prices matter in their own right, because wild swings in asset prices, even in the context of "stable" goods and services inflation, are a source of both volatility and maldistribution in investment.

And, in the long run, a source of deflationary, not inflationary risk.

Like nonbelievers on their deathbed accepting the tenets of the local religion to ensure safe passage when their eyes are closed one last time, more and more Keynesian economists will likely be reading the works of noted Austrians as the the bubble economy seeks to negotiate the rest of the decade and beyond without running into any pins.

It was just a matter of time before the economy developed a resistance to the credit excess cure that in recent decades has led to such imbalances and malinvestment - in the long run, the Keynsian cure was sure to lose its effectiveness, as foretold by the man himself.

As Keynes once famously said, "In the long run, we are all dead".

His thoughts on the long term prospects were clear.