A response to Alan

By: Wolfgang Münchau

We have had an interesting discussion on the Eurointelligence website about whether and to which extent monetary policy is to blame for the crisis in global credit markets. I believe that there is no point in going after scapegoats, and certainly not after individuals. But the question whether monetary policy has played a supportive role in this crisis is legitimate. In his entry on our EMU Monitor, Alan Ahearne said the focus on alan Greenspan by some commentators, including our own ECB Watch, was mistaken, while one should instead focus on the real culprits, reckless mortgage lenders, greedy investors, and rating agencies among several.

 

We know from history that there are profiteers from any financial crisis; we also know that economic agents display an irrational behaviour during such periods (would you mortgage your house for a tulip bulb?). While human fallability is always a factor in a boom-bust ride on financial markets, many financial crises in the past were made worse by policy.

 

There are now different assessments of the Fed’s policy record between 2001 and 2004. Alan believes that the Fed was right to cut interest rates in response to the 2001 recession, and then again to the September 11 attacks. He argued further that the Fed was right to pay an insurance premium against the threat of deflation, which he argued was real at the time. The fact that deflation did not surface, he implied, was due to those very policies, not to a misjudgement of the threat itself.

 

I disagree with that analysis. The Fed, like the rest of the US, overreacted to September 11. That may be a harsh statement to make, and Americans get twitchy when Europeans make it. But it is nevertheless true. The US overreacted politically, and it overreacted economically. The Fed was, of course, right to cut nominal interest rates during the recession, but the Fed was not right to opt for negative real interest rates, and to leave short-term nominal rates at 1% for a year. The loose monetary conditions have no doubt encouraged a large amount of activity in the credit market. It has turned what would have been risky investments into riskless bets. It encouraged carry trades, which are a no-brainer when interest rates are negative; it encouraged a housing boom of unprecedented proportions, as everybody gained from the most reckless lending practices. For a long time, sellers and buyers in the housing market  knew that house prices would rise faster than the cost of finance. In such an environment, it was entirely rational for people to take on levels of debts that would be considered excessive under normal circumstances. The Fed’s interest policy gave rise to numerous Ponzi schemes, the effect of which we are now seeing.

How real was the threat of deflation? Would a more moderate interest rate policy by the Fed – say a reduction in short-term rates to 2.5% have produced deflation? The leading participants in this debate were academics who feared the US might experience a similar fate as Japan, and these academics clearly feared deflation a lot more than inflation. But as Adam Posen has pointed out in 2003 it takes more than a deflating asset price bubble to become Japan. Japan did not suffer a particular serious recession during the early 1990s. What turned the recession into a deflationary depression was a series of policy mistakes, especially the failure to reform a seriously dysfunctional banking sector. The situation in the US, which had just come out of recession, did not warrant negative real interest rates. The Fed fought yesterday’s war, as indeed did George W. Bush.

 
Our policy response this time should be more moderate. That does not imply that central banks should not cut interest rates when they see real economic effects as a result of the credit crisis. There is a reasonable case to be made for a reduction in interest rates in the US right now. But central banks must beware not to plant the seeds for the next bubble. Cutting interest rates by 100 points or more, as some economists are now demanding to support the US economy, and Wall Street, would be a serious mistake, especially since this nobody can really claim that we are facing the prospect of deflation.

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