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Monday, August 25, 2008


the huge news out of jackson hole

underreported and underappreciated as far as i can tell, but mentioned in the new york times.

former bank of england policymaker and credit iconoclast willem buiter savaged the federal reserve's policy response to the credit crisis at the fed's annual hoedown in jackson hole. he accused bernanke of being the kept man of wall street banks, doing their bidding at the expense of the fed's reputation as an inflation fighter, putting efforts to sustain the mispricing of credit ahead of sound monetary policy.

but that is not news. what is news is that five of the eleven voting members of the federal open markets committee essentially agree.

The view expressed by Professor Buiter, however — that a central bank’s overriding concern should be fighting inflation, while a sinking economy is left to be refloated by other means — is welcome thinking for the five or so Fed policy makers, all of them presidents of regional Fed banks, who say that the Fed must begin to raise rates right away.

Mr. Bernanke, in a speech here, said that inflation is likely to moderate as commodity prices come down and the dollar stabilizes. But the Fed bank presidents who want a rate increase now say that he is missing the point. Unless the Fed takes action, they say, people will lose faith in it as a guardian against a rising inflation rate.

“These hawks at the Fed are arguing in effect that we have to throw people out of work more quickly than we already are to ensure against inflation,” said Jan Hatzius, chief domestic economist at Goldman Sachs.

So far, only one of the policy makers is pushing for higher rates. Richard W. Fisher, president of the Federal Reserve Bank of Dallas, has voted for a rate increase at recent Fed policy-making meetings, casting the lone dissenting vote among the Fed’s 11 voting governors and regional bank presidents. The other dissenters have voted with the majority to keep the key federal funds rate at 2 percent, actions that have muted their criticism of this approach.

Now, however, Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia, is likely to join Mr. Fisher. Twice in the past, Mr. Plosser had cast a dissenting vote along with Mr. Fisher, the last time at the April 30 meeting, when the policy makers completed their rate cuts, bringing the federal funds rate to 2 percent. Ever since, he has voted with the majority and in doing so, he has maintained a silence that he says he intends to end soon.

“If we don’t reverse our accommodative stance sooner rather than later,” Mr. Plosser said in an interview here, “we will face rising inflation, which may be costly to deal with, and we will face a risk to the Fed’s credibility to contain inflation.”

meanwhile, the parry of bernanke's defenders is well contained here.

Assigned the task of critiquing the paper was Alan Blinder, the former Fed vice chairman, who gave high marks to the central bank. Mr. Blinder brought his point home to the crowd with a tale of a little Dutch boy (Mr. Buiter was born in the Netherlands), entertaining the crowd of international central bankers, academics and Wall Street economists:

One day a little Dutch boy was walking home when he noticed a small leak in a dike that protected the people in the surrounding town. He started to stick his finger in the hole, but then he remembered his moral hazard lesson. “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout. And doing that would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a floodplain.” The boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned, including the little Dutch boy.

Mr. Blinder continued: “You might have heard an alternative version of this story circulating around the Fed.”

In this kindler, gentler version, the little Dutch boy, somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. … It was painful. The little Dutch boy would much rather have been somewhere else. But he did it anyway. And all the foolish people who live behind the dike were saved from the error of their ways.

this is a rather unfortunate analogy. while it must greatly assuage the egos of the central bankers involved, elevating their role to the heroic, it is false.

a more honest analogy would be to replace the dike with a dam -- holding back not a passing storm surge but the accumulating force of a river. while storms pass and their effects are transient, rivers continue to flow -- and the force of their retained water, rather than abating, inexorably grows.

central banking policy over the last seventy years (and more acutely the last twenty) have prevented at each potential intersection the credit market from reaching the clearing prices of maximum pessimism. in this revised analogy, the policy aim has been not to maintain the dam but to narrow the spillways designed to ensure that the force of the water behind the dam does not endanger the dam itself. the absence of those episodic cathartic events over a long span has already encouraged the buildup of systemic (as opposed to cyclical) debts, which have grown so large as to represent a mortal threat to systemic integrity -- the accumulated water behind the dam is very high now, and forcing the dam to crack. this leaves men like bernanke with the opportunity to cast themselves as heroes as they, while feverishly filling the cracks with their fingers, manage also lay the last few bricks to seal up the spillways completely.

central bankers like bernanke and blinder talk about moral hazard like it is a potential problem; this highlights just how narrow their view and tenuous their grasp of the underlying reality is, deluded by decades of apparent success that really amount to consistently storing up bigger trouble for the future. moral hazard has been the problem since monetary policy became a countercyclical weapon in the 1930s, indeed since the founding of the federal reserve bank in 1913.

i sympathize with blinder's view -- if rates are raised, the dam may well break. but what blinder does not seem to realize -- even in light of graphs like this -- is that if the dam isn't allowed to break today, it will shortly overtop and come crashing down. their little dutch policy, far from having nobly attempted to save the ageing baby-boom generation from "unnecessary" pain, will have surely imperiled and summarily destroyed them in their dotage and their children besides.

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Your 'Army Corps of Engineers' analogy is both apt and well articulated-I've used this myself (another apt one is 'The Sorcerer's Apprentices' from Fantasia...)
Storing up trouble for THE BIG ONE.

Whom the gods would destroy, and all that...


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ps Gaius-your blog is fantastic: your knowledge of history and geopolitics lend a gravity that other 'finance' blogs will never have...Thank you!


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thanks chuck -- that's too high of praise!

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