August 4, 2008

Are the Liquidationists Starting to Raise their Heads?

Princeton economist and NY Times columnist Paul Krugman makes an excellent point in his NY Times blog:
Ken [Rogoff] tells us that
The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast.
And then he calls for
a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels
Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen — which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?
Ken Rogoff's point can be understood in a more limited sense. We do need an actual reduction in the relative size of the financial sector, which has grown way out of its intrinsic value. But that doesn't mean that economic activity in itself should slow down.

The transition from financial labour to more productive uses does entail some amount of higher unemployment. It does take some time for all the extra mortgage professionals to find a more productive employment. But this process of adjustment has started to happen on its own. There is no need (anymore) to help it on by excessive tightening of monetary controls.

The instinctive reaction to long dormant inflationary pressure that is suddenly fully revealed is quite similar to a person in a rocket that has been launched in a gigantic thrust and is comfortably looking at the sky (growing asset prices). Then the upward momentum runs out (we are entering a permanently high plateu...). The rocket turns towards the earth (existing stimulus moves from assets to commodities).

Now what is the appropriate response? Some people have just only come to realize that we are way too high and heading downwards. Their instincts are saying: If we keep the thrusters on, we will crash into the earth.

But this is a wrong reaction. This parable is completely bogus. The "thrusters" have not been on for a while. And we are not in a rocket in which the thrusters are always behind us. What we have is closer to a hot air balloon (pun intended). The burners were on for too long when we left the ground.

Monetary stimulus works quite like the torch in a hot air balloon. It has no immediate effect on the level of lifting force. Instead it builds up a reserve of lifting force quite like the temperature in a balloon.

And we do need some extra lift to keep us from falling straight to the ground. We can not, and should not try to keep permanently high, or we risk running out of fuel. But we do need to slow down the fall.

But fall we will. The global imbalances are too great. But we should not try to accelerate these inevitable changes. They will manifest by themselves. We should try to land as fast as we safely can without running out of fuel.

Some people have been looking to the clouds far above, and have only recently come to realize how very far we actually are from the ground below. For some of these people the immediate reaction to the sudden realization is "full speed down!". This is the liquidationist viewpoint. "Puncture the bubble!". It could have been fine in the beginning (and some have been calling it as it is), but will result in a very hard landing if rigorously applied at this "altitude".

Our current altitude is a matter of reality. We have a massively out-of-size financial sector and a global economy that is quite heavily out of whack. Some people think that this condition can be kept forever. But should we attempt that, we would surely run out of fuel. We are actually quite close to that situation. And it would result in a crash just as devastating as the liquidationist approach, only somewhat later.

What we have is a pretty tricky situation. We should not aim for a permanent bubble. And we should not aim for immediate deflation. We should aim for a steady brisk pace of continuous adjustment until the financial "industry" is the size of its actual utility, productive labour has the value that it should, and people would by paid around the globe according to their actual productivity.

In that sense Ken Rogoff is right. We do need to head down. But we do need to head down by careful administration of the torch. Not by letting the balloon completely deflate.

And Paul Krugman is exactly right. There is no sense in underutilization of labour and capital. Closing down factories and cutting down production produces nothing but poverty. Collectively we can't keep wealthy just by holding cash or government bonds.

The currently low interest rates are more a function of people wanting to hold secure government bonds than any sign of excessively "loose" monetary policy. The Federal Reserve has actually been withdrawing money in its open market operations. The overall liquidity has been stagnant, while the money has been pumped back into the system through various special lending facilities.

Unfortunately US monetary policy is now quite irrelevant. Bank accounts are primarily made of promissory notes, and cash is just a tiny fraction. When banks stop lending, the money supply shrinks on each payment that the public makes to banks, including interest and equity injections.

Money came from thin air, and to the same place it disappears. And the less there are actual deposits, the less banks have any need for cash, and the harder it is to try to slow down the collapsing bubble through monetary policy action. The zero interest limit (and running out of "fuel") awaits.

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