We'll Need Helmets, not Hairshirts

The mainstream financial media is increasingly questioning Federal Reserve monetary policy in light of the now almost universally acknowledged housing bubble, mammoth trade deficit, and various other related imbalances in the global economy.

The developing pattern of discussion about monetary policy is eerily reminiscent of the early stages of the discussion about the housing bubble, which seemed to progress through three stages:

1. Lots of talk about whether or not a problem exists
2. General acceptance that there really is a problem
3. Predicting how unpleasant things might get
   

While the housing bubble discussion is now clearly entering stage three, discussion of monetary policy seems to have entered phase one.

Wall Street Journal

A few weeks back Greg Ip of the Wall Street Journal noted that since the stock bubble burst in 2000, and after three years of super-low interest rates and lending standards, Americans have borrowed and spent like never before, creating a self-reinforcing housing boom which has added nicely to both growth and employment statistics. With the debt and current account statistics even more impressive than either growth or employment, Greg wonders how things will ever get back to normal:

"How that will happen puts the nation in uncharted territory: After treating a bubble, how does the Fed manage the side effects of its medicine?"

The phrase "uncharted territory" seems to be popping up all over the place these days - Mr. Greenspan has used this term during recent congressional testimony and Fed Governor Kohn also seems to be fond of it.

In this same article, in what is destined to be a classic analogy for this era, a former Fed governor expands on the uncharted territory theme:

"We have done what no other economy has done before, faced with an asset bubble," Lawrence Lindsey, a former Fed governor and Bush adviser, said at a recent panel discussion. Praising both the Fed's rate cuts and Mr. Bush's tax cuts, he said, "This is the first time in history the textbook economic policy... was used, and worked. The problem is, once you finish that chapter of the economic texts, you turn the page and the page is blank -- because no one has gone through the process before."

The textbook that Mr. Lindsey is of course referring to is the one that was written after the Great Depression. The one that says, if we are ever dumb enough to create another asset bubble like the one that preceded the Great Depression, let's inject enough money and credit into the system to make the magnitude of the bust much smaller than the magnitude of the boom.

That's where the textbook ends ... that's where we are today.

BusinessWeek

Then last week, Chris Farrell at BusinessWeek penned Alan Greenspan: Wizard or Villian?, in which he apparently decided that the best defense was a good offense - that "hairshirt" economics, responsible for the extended pain and suffering of the Great Depression, should be acknowledged then again discredited, lest this thinking work its way back into mainstream economics.

[Now, admittedly, "villain" is a hard word to spell correctly, but you'd think that someone would have hit the spell check button at some point in the process of publishing this article. Newsflash - 8/19/05 - the spelling has been corrected]

Greenspan-bashing is now a popular sport among the Masters of the Universe. One reason is that the 10-year economic expansion came to an end with the dot-com bust and subsequent recession. Another is that Greenspan's standing as the Monetary Maestro was overhyped during the halcyon days of the 1990s. And the third is that his fallibility as a central banker was overemphasized during the difficult economy of the early 2000s. Indeed, the chairman has never recovered his lost luster.

Still, Greenspan's most vehement critics go a lot further than this. They're convinced he has made a fundamental error as a monetary economist. Call it the hairshirt economists vs. the cheerleaders for growth-is-good. The hairshirts believe that for the health of the economy to be restored, the inevitable bust that follows a boom must be at least as great as the boom. Growth proponents -- and there's none greater than Greenspan -- believe that it's better to limit the fallout of a bust and get the economy growing again as quickly as possible.

So, here's one of the many people in the world who think that the biggest stock market boom in history is logically followed by the shallowest recession in recent history - that more easy money is the solution to all problems, even if these problems were caused by easy money.

Lunches really can be free and perpetual motion machines do exist.

While it seems to have worked this way for a while, it is not likely to work this way forever. When this theory was adopted, the U.S. was an emerging economy on the gold standard. Today we are an aging economy with a fiat currency - with a government that has made promises that it can't keep, while at the same time engaging in wars it can't pay for and assuring its populace that its standard of living will endure.

In fact, the real possibility that this is a fundamentally flawed theory that is looking more fundamentally flawed every day, is quite possibly why more and more economists seem to doubting the chief economist, Mr. Greenspan.

Look, Greenspan is no economic wizard, and this isn't a brief to defend him. He has made his share of mistakes, although fewer than many of his predecessors. But what should be defended is the economics of growth. Remember, not all price increases are bubbles, booms are better than busts, and growth is not only good -- it's vital.

So, a growth-is-good cheerleader, knowing full well that the head cheerleader is perplexed by the situation in which he finds himself, pleads for more growth - to just pump more money into the system.

It's always worked before - anything but hairshirts.

Like the housing bubble a year or two ago, the monetary policy problem is now being talked about a lot - clearly we are in stage one of the process outlined earlier. When monetary policy becomes generally accepted as being a problem, we will have progressed to stage two, at which time a few people may begin speculating about how unpleasant things might get.

Then many will realize that ... we'll need helmets, not hairshirts.