Can we save American capitalism?
.
By Steven Pearlstein
.
Published: August 31
.

 

 
 
A dozen Labor Days — and three presidential electionsago, the world was in the thrall of American-style capitalism. Not only had it vanquished communism, but it was widening its lead over Japan Inc. and European-style socialism.
.

.
Today, that economic hegemony seems a distant memory. We have watched the bursting of two giant financial bubbles, wiping out the paper wealth many of us thought we had in our homes and retirement accounts. We have suffered through two long recessions and a lost decade of income growth for the average family. We continue to rack up large trade and budget deficits. Virtually all of the country’s economic growth and productivity gains have been captured by the top 10 percent of households, while moving up the economic ladder has become more difficult. And other countries are beginning to turn to China, Germany, Sweden and even Israel for lessons in how to organize their capitalist economies.

.

It’s no wonder, then, that large numbers of Americans have begun to question the superiority of our brand of free-market capitalism. This disillusionment is reflected not only in public opinion polls but on the shelves of American bookstores, where the subject has attracted many of the best economists in the country. Retooling American capitalism has become something of an national — and even international — obsession.
.

.
Capitalism has always changed in order to survive and thrive. It needs to change again,” writes Martin Wolf, the uncompromisingly pro-market columnist for the Financial Times, in an essay in The Occupy Handbook.”
.


.
It would be giving the current presidential campaign too much credit to say that it has become the forum in which Americans will decide what kind of capitalism they want, unless you count the “na-na na-na na-namudslinging over Mitt Romney’s outsourcing and President Obama’s welfare regulations. The closest it has come has been the discussion over the president’s inartful comment about business owners who did or didn’t build” their success.
.

.
Although the Republican spin machine reflexively took entrepreneurial umbrage at Obama’s notion that it takes a village to create a successful company, each of the books reviewed here essentially embraces the idea. A pure market economy is an ideological fantasy; even the freest markets operate in a framework of laws, infrastructure, institutions and informal norms of behavior in which government is heavily implicated. Our challenge is in getting that framework right.





Of course, there are some who want to leave American capitalism well enough alone. They include Allan Meltzer, a conservative professor of political economy at Carnegie Mellon University, who adopts the Churchillian view that while capitalism has its deficiencies, it’s better than the alternatives. He spends much of his short book, Why Capitalism?,” knocking down the old straw men of socialism and communism, as if anyone in America is seriously proposing them these days.
.

.
You know Meltzer is spending too much time rereading Kant and Locke when he declares that capitalism’s secret is how well it disperses political and economic power, oblivious to the new role of money in U.S. politics or the harsh realities of global competition — a view that may come more naturally to someone on a campus endowed by the Carnegies and the Mellons. It is precisely this failure to disperse wealth and power that animates our disillusionment.
.

.
Under the heading of ignoring reality, however, it would be hard to beat Edward Conard, who makes the intriguing argument that there never was a credit bubble or a housing bubble, that large and persistent trade deficits are a sign of economic strength, that booms and busts are a good thing, and that what we really need is more income inequality, not less.
.

.
It is unlikely that anyone would be giving Conard’s fantasies a moment’s thought but for the fact that he was a Romney collaborator at Bain Capital in the 1990s and that he set up a front company last year to give $1 million to a super PAC supporting Romney. In Unintended Consequences,” Conard contends that the past decade and a half was a golden era for American capitalism. Corporations, money managers and wealthy investors poured massive amounts of capital, much of it unrecognized by accounting rules, into new ideas and technologies. This triggered a productivity boom so strong, it allowed the U.S. economy to employ not only all willing Americans, but tens of millions of Mexican immigrants and Asian factory workers.
.

.
And while it may appear to the envious that a few people got very rich in this process, Conard’s tortured calculations lead him to conclude that 95 percent of all the economic benefit from this boom spilled over to workers and consumers in the form of higher wages, greater wealth, and cheaper goods and services.
.

.
The only way to recapture that golden era of high growth, low unemployment and booming stock markets, Conard suggests, is to eliminate all taxes on the very rich so they can make even more investments in new ideas and innovative new companies. At the same time, we should just give up manufacturing, move all the talented people into high-tech and financial fields, and leave everyone else to tend the children and gardens of the talented.
,

.
This masterpiece of faulty logic, selective data and moral vacuity is premised on misguided assumptions: that product and financial markets are perfectly competitive, that compensation is an accurate reflection of a person’s productivity and that investment is immune to the law of diminishing returns. It also reflects the intellectual arrogance of the corporate-strategy consultant and private-equity manager that Conard once was.
.

.
I suspect it would never occur to Conard to question whether more is always better when it comes to economic growth, but that is very much the issue at the heart of Robert and Edward Skidelsky’s How Much Is Enough?
. 

.
The Skidelskys come naturally to the topicson Edward is a philosopher at the University of Exeter, and father Robert is an economist at the University of Warwick and the best-known biographer of John Maynard Keynes. It was Keynes who predicted that by 2030, the productivity of workers in advanced economies would be so enhanced that people would be able to live better and work half as many hours. (Keynes’s projections about productivity and income have proved spot on; those about work hours, not so much.)
.

.
The Skidelskys set out several reasons for what they view as our bad trade-off between income and leisure. For starters, many of us take pleasure and meaning from our work, and because of growing inequality, there are still many among us who do not have access to all the basics.
.
.
.
For those near the top, happiness and satisfaction tend to be tied up with the acquisition of status goods: vacation homes on the shore, meals at the better restaurants, education for their children at elite schools. Because these goods are in limited supply, their relative price has risen faster than incomes, requiring people to work longer hours to afford them.
.

.
Meanwhile, the extra leisure we crave invariably involves expensive travel or fancy club memberships, whose costs also require us to work more.
.

.
The Skidelskys think we’d all be happier — and have a better society — if we reduce inequality (through progressive taxation and a stronger safety net), temper the arms race for status goods (through a consumption tax) and expose people to pleasures that don’t require large expenditures (through more of the traditional liberal arts education).
.

.
To an American ear, theirs sounds like a rather old-world, upper-class notion of “the good life.” And their version of “non-coercive paternalism” would quickly run afoul of our individualism and our distrust of anyonelet alone British dons or American politicianstelling us how best to spend our time and money.





A more practical reform idea comes from Roger Martin, dean of the Rotman School of Management at the University of Toronto. Once a partner at the Boston Consulting Group, Martin saw corporate America from the inside and has a pretty good fix on why it has lost its way: its single-minded focus on maximizing shareholder value.
. 

.
In Fixing the Game,” Martin argues that there are two markets in which big companies operate. There is the real market, where the company wins or loses by selling products and services. And there is the “expectations market” — the stock market where people wager on the company’s prospects. In this market, what matters is not the company’s actual profits but whether those profits meet expectations.
.

.
As Martin sees it, the problem comes when the people who run big businesses are rewarded for winning not in the real market but in the expectations market. And what that means in practice is constantly raising expectations about future profits. Eventually, these expectations grow so inflated that they are impossible to realize without manipulating the books (think Enron) or taking undue risk (think Lehman Brothers or AIG). In either case, it requires diverting time and attention from the real market, where actual long-term value and wealth are created.
.

.
As Martin notes, it was only in the mid-1970s that winning in the expectations market — a.k.a. “maximizing shareholder value” — began to be considered the sole purpose of a corporation. That prompted companies to start offering extravagant grants of stock and stock options to top executives. Unfortunately for investors, Martin writes, the returns of the 500 largest U.S. corporations have been lower, not higher, since shareholder value became the holy grail. As for that executive pay, he calculates that it has grown eight times faster than the reported profits of the companies those executives run.
.

.
“The expectations game is beginning to destroy the real game,” Martin concludes. The way to stop it, he says, is for American business to adopt a broader, healthier definition of its purpose, and reflect that in the way executives and money managers are compensated and the way corporations are governed.
.

.
Martin’s skepticism about Wall Street is not shared by Robert Shiller, the Yale finance professor who sounded an early and prescient warning about the recent real estate bubble. Shiller is a brilliant and original thinker, but Finance and the Good Society is a disjointed and unconvincing argument that financial innovation can be used to tame the excesses of capitalism rather than aggravate them.
.


Shiller proposes to “democratizefinance with new products such as insurance that would protect homeowners against dramatic declines in their home’s value. He imagines a “dynamictax code in which rates shift to offset changes in the way private markets are distributing income.
.

.
The problem with such suggestions is that they ignore the key lesson from the recent financial crises: The more complex finance becomes, the greater the information and knowledge gap between the Wall Street sharks and everyone else. The growth of such information asymmetries over the past 25 years makes Shiller’s proposals look naive.
.

.
As a professor at the free-market-oriented University of Chicago, Luigi Zingales is hardly the person you’d expect to be calling for a renewed populism. But as a native Italian, Zingales has a particular sensitivity to public and private corruption. His thesis is that most of our problems stem from special interests using government policies and regulation to create a kind of crony capitalism.
.

.
Lack of competition and the distortions created by government subsidies are the primary causes of all the problems we face in the economy today, including the declining real incomes of middle-class America,” Zingales writes in the introduction to A Capitalism for the People.”
.

.
In this accessible and powerfully argued book, Zingales calls for a capitalism that is not pro-business but pro-market, that celebrates meritocracy but not inherited privilege, that emphasizes the accountability of economic actors as much as their freedom and discretion. The essential element of capitalism, he argues, is full and open competition, and it is only when competition is absent that you get the kind of inequality, instability and class rigidity that Americans have recently experienced.
.

.
Zingales’s diagnosis and his prescriptionseducation reform, bankruptcy reform, income-based student loan repayments, tougher consumer protection and antitrust enforcement, limits on corporate lobbying and campaign contributions, stronger investor control of corporate governance and executive compensation, wider whistleblower protections and class-action remedies — are strikingly similar to those offered by Joseph Stiglitz, the Nobel Prize-winning Columbia University economist who comes from the other end of the ideological spectrum.
.

.
Although better known in academic circles for his work on market imperfections, Stiglitz’s doctoral dissertation was on how too much income inequality reduces economic growth. He updates that theme in The Price of Inequality,” showing how inequality undermines productivity, leads to wasteful competition for status goods and allows the rich to convert their wealth into political power, which they use to further tilt the playing field in their favor.
.

.
The threat of plutocracy — a democracy taken over by the wealthy and run for their benefit — is a theme running through not only Zingales’s and Stiglitz’s analyses but a number of the other books as well. They raise the specter of the country being sucked into a dangerous spiral in which inequality, class rigidity and economic instability breed more of the same.
.

.
“The basic premise of the ‘mixed economy’ is that market dynamism can be combined with democratic equality,” Columbia University economist Jeffrey Sachs writes in “The Occupy Handbook,” a collection of essays prompted by the Occupy Wall Street protests and written by authors from across the ideological spectrum. “The overriding political and financial power of corporate capitalism has nearly obliterated the functioning of the mixed economy, with the state in retreat or mainly serving corporate interests.”
.

.
“In the absence of a properly functioning set of protections, the bazaar (the sphere of the market) consumes the forum (the sphere of politics),” adds the Financial Times’ Wolf in the same volume. “The outcome is rule by affluent vested interests or, quite simply, plutocracy.”
.

.
Were he alive today, no less a free-marketeer than Adam Smith would readily acknowledge that a capitalist system forfeits not only its economic rationale but its moral justification if all its benefits are captured by a tiny slice at the top of society.
.

.
What’s been lost from American capitalism is any sense of a larger purpose, of how it fits into and serves society, broadly speaking — or as the Skidelskys would put it, how it contributes to a “good life” that is both individual and collective.
.


In the current, cramped model of American capitalism, with its focus on output growth and shareholder value, there are requirements for financial capital, human capital and physical capital, but no consideration of what Stiglitz callssocial capital,” Zingales calls “civic capital” and Martin calls the “civil foundation.” It is this trust in one another that gives us the comfort to conduct business, to lend and borrow, to make long-term investments and to accept the inevitable dislocations of the economy’s creative destruction.

.
.
Whatever you call it, societies do not thrive, and economies do not prosper, without it.
.

.
This erosion is most visible in the weakening of the restraints that once moderated the most selfish impulses of economic actors and provided an ethical basis for modern capitalism. A capitalism in which Wall Street bankers and traders think it is just “part of the game” to peddle dangerous loans or worthless securities to unsuspecting customers, a capitalism in which top executives have convinced themselves that it is economically necessary that they earn 350 times what their front-line workers do, a capitalism that puts the right to pass on unlimited amounts of money to undeserving heirs above the right to basic, life-saving health care — that is a capitalism whose trust deficit is every bit as corrosive and dangerous as its budget and trade deficits.
.

.
As Zingales notes, American capitalism has become a victim of its own success. In the years after the demise of communism, “the intellectual hegemony of capitalism led to complacency and extremism: complacency through the degeneration of the system, extremism in the application of its ideological premises,” he writes. “Money regardless of the way it was obtainedensured not only financial success but social prestige as well. ‘Greed is good’ became the norm rather than the frowned-upon exception. Capitalism lost its moral higher ground.”
.

.
So where is a blueprint for a new American capitalism likely to come from? Probably not from economists or journalists, or even from politicians in Washington or on the campaign trail. As Meltzer would say, the genius of democratic capitalism, and democracy, is that the new norms of economic behavior are likely to emerge from executives and entrepreneurs, workers and consumers, money managers and bankers who find the courage to demand something better of themselves and others.
.



Steven Pearlstein is a business and economics columnist at The Washington Post and the Robinson professor of public and international affairs at George Mason University.

.
The Consequences of Easy Monetary Policy

By John Mauldin

Sep 01, 2012




"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."
.
 .
- Ludwig von Mises





We heard from Bernanke today with his Jackson Hole speech. Not quite the fireworks of his speech ten years ago, but it does offer us a chance to contrast his thinking with that of another Federal Reserve official who just published a paper on the Dallas Federal Reserve website. Bernanke laid out the rationalization for his policy of ever more quantitative easing. But how effective is it? And are there unintended consequences we should be aware of? Why is it that the markets seem to positively salivate over the prospect of additional QE?




.
Got LSAP?
.


.
No one really expected any fireworks in Bernanke's speech, and he fully met expectations. We got the obligatory rationalization for what passes as current Fed policy. The part the markets wanted to hear is highlighted below for you.




"… As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.




"Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability."



Did that last sentence ring any bells? Let's look at his Jackson Hole speech in August of 2010 (hat tip Joan McCullough).





"We will continue to monitor economic developments closely and to evaluate whether additional monetary easing would be beneficial. In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool."




Standard-issue Fed speech. This has been his theme for the last four years, if memory serves. In every speech he gives a nod to the proposition that he and his colleagues are seriously analyzing the effects of Fed quantitative easing policies to make sure the benefits outweigh the costs. I have not heard a serious critique or exposition from Bernanke of those risks, as of yet. But we did get a victory lap from him this year, as he took credit for the economy and the stock market. Let's go back to the speech (again, my bold):



"Importantly, the effects of LSAPs [large-sized asset purchases] do not appear to be confined to longer-term Treasury yields.




"Notably, LSAPs have been found to be associated with significant declines in the yields on both corporate bonds and MBS. The first purchase program, in particular, has been linked to substantial reductions in MBS yields and retail mortgage rates.




"LSAPs also appear to have boosted stock prices, presumably both by lowering discount rates and by improving the economic outlook; it is probably not a coincidence that the sustained recovery in US equity prices began in March 2009, shortly after the FOMC's decision to greatly expand securities purchases. This effect is potentially important, because stock values affect both consumption and investment decisions."



I missed the part where Congress gave the Fed a third mandate, to target the stock market. But Bernanke not only takes credit for the stock market, he points out that the rebound in the housing market is also due to Fed policy, because it fostered lower mortgage rates. Which it did. But let's also remember that it was Fed policy that helped create the housing bubble to begin with. Which I don't remember Bernanke taking credit for, even though he was on the Fed then and up to his eyeballs in supporting that policy.


.
Joan McCullough, in her own irreverent style, gave us a few must-read paragraphs this afternoon:




"And then [Bernanke] has the sand to make a public comment that stocks go up when he prints money because discount rates have gone down and the economic outlook has improved on account of it? This is what makes the hot dogs run stocks up the flagpole when The Bernank saddles up? Better economic outlook? Amazing.




"Lemme go back now and give you the reality version of the Bernanke portfolio balance channel.




"He relieves investors of the lowest risk-bearing vehicles, forcing them to seek yield elsewhere and at the same time, take on increasing risk. Until, increasingly yield-starved as this 'balancing' is relentless, they arrive at the door of the stock market. And mindlessly take the plunge. Because they have no choice. They are now balls-to-the-walls exposed. Waiting for the next round of QE.



"Because Lord knows, the first two did jack. Of course, in the earliest part of his diatribe today, he does make a case as to how the lower rates worked some magic on the economy, although exactly how much is difficult to pinpoint. As usual, too, he also blames the fiscal intransigence as well as tight credit conditions at the banks for holding back the beauty of his genius from working its total magic."



.
Quantitative Easing as Trickle-Down Economics



.
Let me get this straight. If I design a tax policy that somehow might benefit "the rich," I am immediately labeled a Luddite supply-side theorist, as well as heartless, etc.




It is pretty standard for Keynesian economics professors to deride supply-side economics and what they call trickle-down economics. Cutting taxes on the rich will translate into a better economy and jobs? They scoff at such notions, as do almost all the liberal elements in politics.




Which brings us to this delicious irony. While they abhor trickle-down economic policy, they love what is in effect trickle-down monetary policy.



Bernanke explicitly targets a policy of helping the rich (those who own stocks) and then suggests that the result of making the rich richer will be increased consumption and final demand. Which will somehow trickle down to the guys and gals in the unemployment line.




The paper posted at the Dallas Fed, which we will take up in the next section, specifically notes that QE has a special benefit for "the senior management of banks in particular." That amounts to a thunderous indictment of the crony capitalism of current policy. It's hard to argue that there is much trickle down with that particular unintended consequence!




The paper also notes that "… it is also worth asking whether, to some degree, this [rising income inequality] might be another unintended consequence of ultra easy monetary policy. Not only has the share of wages (in total factor income) been declining in many countries, but the rising profit share has been increasingly driven by the financial sector [which explicitly benefits from QE]. It seems to defy common sense that at one point 40 percent of all US corporate profits (value added?) came from this single source."





Understand, I am NOT arguing that an easy monetary policy doesn't have an effect on stocks and that it will have an effect on the overall economy. There is clearly a wealth effect. It is just that almost all (not quite but almost) of the arguments that one can make for trying to boost the stock market are the same that one uses for arguing that tax cuts also increase consumption and the wealth effect.




As a short preview to next week's letter, Christina Romer and her husband and fellow UC Berkeley professor, David H. Romer, published a paper in the normally staid American Economic Review which noted that tax cuts and increases have a multiplier of about 3. (Christina Romer was Obama's chair of the Council of Economic Advisors, from the beginning of his term until [very] shortly after this paper was published.)





Most mainstream economists and liberals (or those who are both, as in the case of Krugman) make fun of the wealth and economic effects from tax cuts and ignore Romer's work, or try to show why it does not apply to eliminating the Bush tax cuts, which they oppose (and which, interestingly, the Romers' study specifically included). But then they turn around and ask for more of what is effectively the same thing in monetary policy. It will be great fun to watch the contorted positions they have to assume in trying to suggest this is not the case. Kind of like the contorted position that Clint Eastwood was referring to last night. They will use anecdotal "evidence" and allegories without actually referring to academic analysis or peer-reviewed studies. It is much easier to make an assertion than to actually demonstrate its validity in the real world. Their antics will serve to drive me nuts, however.




Note that I am not saying that either tax policy or monetary policy should be evaluated in the harsh glare of immediate economic results. Taxes have to be evaluated on more than just their effect on the economy, and monetary policy has to be judged on more than the immediate reaction of the markets.



.
That Which Is Seen and That Which Is Not Seen



.
Which brings us to the more serious part of this letter. Let's start with a review of a quote from Bastiat:



"In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.



"There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.



"Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Hence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil."



- From an essay by Frédéric Bastiat in 1850, "That Which Is Seen and That Which Is Unseen" "



.
Ultra Easy Monetary Policy and the Law of Unintended Consequences




.
"William R. White is currently the chairman of the Economic Development and Review Committee at the OECD in Paris. He was previously Economic Advisor and Head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland. He is clearly no economic lightweight, nor is he an ideologue. When he writes, attention must be paid. (http://williamwhite.ca/content/biography)



And he has written a rather pointed indictment of Federal Reserve monetary policy, which has been published on the Dallas Federal Reserve website.





Basically, he looks at the unintended consequences of quantitative easing and concludes that there are limits to what central banks can do, and negative consequences if policies are too easy for too long. He notes later in the essay that:



"Stimulative monetary policies are commonly referred to as 'Keynesian'. However, it is important to note that Keynes himself was not convinced of the effectiveness of easy money in restoring real growth in the face of a Deep Slump. This is one of the principal insights of the General Theory."




I am going to quote him at length in the next few pages. I hope that it intrigues you enough that you will want to go and read the paper yourself. This is not just dry theory. If QE is maintained for too long, then those of us in the "cheap seats" will have to deal with the consequences. Let me note that there are some 126 footnotes. I would recommend at least keeping up with them, as I found the "extra" commentary to often be very enlightening. This is a well-written paper that avoids the all-too-typical verbal garbage that passes for economics writing these days.




Let's start with his introduction:




"The central banks of the advanced market economies (AME's) have embarked upon one of the greatest economic experiments of all timeultra easy monetary policy. In the aftermath of the economic and financial crisis which began in the summer of 2007, they lowered policy rates effectively to the zero lower bound (ZLB). In addition, they took various actions which not only caused their balance sheets to swell enormously, but also increased the riskiness of the assets they chose to purchase. Their actions also had the effect of putting downward pressure on their exchange rates against the currencies of Emerging Market Economies (EME's). Since virtually all EME's tended to resist this pressure, their foreign exchange reserves rose to record levels, helping to lower long term rates in AME's as well. Moreover, domestic monetary conditions in the EMEs were eased as well. The size and global scope of these discretionary policies makes them historically unprecedented. Even during the Great Depression of the 1930's, policy rates and longer term rates in the most affected countries (like the US) were never reduced to such low levels.





"In the immediate aftermath of the bankruptcy of Lehman Brothers in September 2008, the exceptional measures introduced by the central banks of major AME's were rightly and successfully directed to restoring financial stability. Interbank markets in particular had dried up, and there were serious concerns about a financial implosion that could have had important implications for the real economy. Subsequently, however, as the financial system seemed to stabilize, the justification for central bank easing became more firmly rooted in the belief that such policies were required to restore aggregate demand after the sharp economic downturn of 2009. In part, this was a response to the prevailing orthodoxy that monetary policy in the 1930's had not been easy enough and that this error had contributed materially to the severity of the Great Depression in the United States.




"However, it was also due to the growing reluctance to use more fiscal stimulus to support demand, given growing market concerns about the extent to which sovereign debt had built up during the economic downturn. The fact that monetary policy was increasingly seen as the 'only game in town' implied that central banks in some AME's intensified their easing even as the economic recovery seemed to strengthen through 2010 and early 2011. Subsequent fears about a further economic downturn, reopening the issue of potential financial instability, gave further impetus to 'ultra easy monetary policy'.


.
"From a Keynesian perspective, based essentially on a one period model of the determinants of aggregate demand, it seemed clearly appropriate to try to support the level of spending. After the recession of 2009, the economies of the AME's seemed to be operating well below potential, and inflationary pressures remained subdued. Indeed, various authors used plausible versions of the Taylor rule to assert that the real policy rate required to reestablish a full employment equilibrium (and prevent deflation) was significantly negative. Such findings were used to justify the use of non standard monetary measures when nominal policy rates hit the ZLB.




"There is, however, an alternative perspective that focuses on how such policies can also lead to unintended consequences over longer time periods. This strand of thought also goes back to the pre War period, when many business cycle theorists focused on the cumulative effects of bank‐created‐credit on the supply side of the economy. In particular, the Austrian school of thought, spearheaded by von Mises and Hayek, warned that credit driven expansions would eventually lead to a costly misallocation of real resources ('malinvestments') that would end in crisis. Based on his experience during the Japanese crisis of the 1990's, Koo (2003) pointed out that an overhang of corporate investment and corporate debt could also lead to the same result (a 'balance sheet recession').




"Researchers at the Bank for International Settlements have suggested that a much broader spectrum of credit driven 'imbalances', financial as well as real, could potentially lead to boom‐bust processes that might threaten both price stability and financial stability. This BIS way of thinking about economic and financial crises, treating them as systemic breakdowns that could be triggered anywhere in an overstretched system, also has much in common with insights provided by interdisciplinary work on complex adaptive systems. This work indicates that such systems, built up as a result of cumulative processes, can have highly unpredictable dynamics and can demonstrate significant non linearities. The insights of George Soros, reflecting decades of active market participation, are of a similar nature."



And then White anticipates his conclusion:



"One reason for believing this is that monetary stimulus, operating through traditional ('flow') channels, might now be less effective in stimulating aggregate demand than previously. Further, cumulative ('stock') effects provide negative feedback mechanisms that over time also weaken both supply and demand. It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the 'independence' of central banks, and can encourage imprudent behavior on the part of governments. None of these unintended consequences is desirable. Since monetary policy is not 'a free lunch', governments must therefore use much more vigorously the policy levers they still control to support strong, sustainable and balanced growth at the global level."




White anticipates the objection that ultra-easy monetary policies clearly had a positive effect early on.





"The force of these arguments might seem to lead to the conclusion that continuing with ultra easy monetary policy is a thoroughly bad idea. However, an effective counter argument is that such policies avert near term economic disaster and, in effect, 'buy time' to pursue other policies that could have more desirable outcomes. Among these policies might be suggested more international policy coordination and higher fixed investment (both public and private) in AME's. These policies would contribute to stronger aggregate demand at the global level. This would please Keynes. As well, explicit debt reduction, accompanied by structural reforms to redress other 'imbalances' and increase potential growth, would make remaining debts more easily serviceable. This would please Hayek. Indeed, it could be suggested that a combination of all these policies must be vigorously pursued if we are to have any hope of achieving the 'strong, sustained and balanced growth' desired by the G 20. We do not live in an 'either‐or' world. "




The danger remains, of course, that ultra easy monetary policy will be wrongly judged as being sufficient to achieve these ends. In that case, the 'bought time' would in fact have been wasted. In this case, the arguments presented in this paper then logically imply that monetary policy should be tightened, regardless of the current state of the economy, because the near term expected benefits of ultra easy monetary policies are outweighed by the longer term expected costs. Undoubtedly this would be very painful, but (by definition) less painful than the alternative of not doing so. John Kenneth Galbraith touched upon a similar practical conundrum some years ago when he said "


.
'Politics is not the art of the possible. It is choosing between the unpalatable and the disastrous'.




"This might well be where the central banks of the AME's [advanced-market economies] are now headed, absent the vigorous pursuit by governments of the alternative policies suggested above."




White then launches into a long litany of unintended and undesirable consequences of maintaining an easy monetary policy too long, some of which we can clearly see developing now. He particularly notes problems with the shadow banking system and the effects of low interest rates on insurance companies (and, I would add, pensions!).




"What are the implications of ultra easy monetary policy for governments? One technical response is that it could influence the maturity structure of government debt. With a positively sloped yield curve, governments might be tempted to rely on ever shorter financing. This would leave them open to significant refinancing risks when interest rates eventually began to rise. Indeed, if the maturity structure became short enough, higher rates to fight inflationary pressure might cause a widening of the government deficit sufficient to raise fears of fiscal dominance. In the limit, monetary tightening might then raise inflationary expectations rather than lower them."




"A more fundamental effect on governments, however, is that it fosters false confidence in the sustainability of their fiscal position Koo, Martin Wolf of the Financial Times, and others are undoubtedly right in suggesting that a debt driven private sector collapse should normally be offset by public sector stimulus. What cannot be forgotten, however, is the suddenness with which market confidence can be lost, and the fact that the Japanese situation is highly unusual in a number of ways."




If interest rates were to rise in the US to more normal levels, the deficit would explode under current spending and tax policies, destroying whatever policy solutions are reached next year.



There is no easy way to exit from current policies, and the longer one waits the more difficult it will get. This is true in the US, Europe, and Japan. It is part and parcel of the Endgame. And this is the defining challenge of our time, and especially in the US as we approach the coming election. I will attempt to outline the key economic issues next week.



Your still on top of his A game and bringing that A game to you every week analyst,


.
John Mauldin





Copyright 2012 John Mauldin. All Rights Reserved.