Monday, January 5, 2009

The Economic Crisis: Are the Inmates in Charge of the Federal Asylum?

One indication of insanity is irrational behavior. A memorable antiwar movie from the late 1960s, King of Hearts (starring Alan Bates and Genevieve Bujold), depicts a British soldier in World War I who finds himself in an abandoned French town, searching for a German time bomb that will blow up the town. He inadvertently opens the door of the local insane asylum. The inmates escape and take up their lives in the town. One of them is a barber, who gives his customers shaves and haircuts, and then pays them. We won't tell you how the movie ends. But this one is worth renting or buying if you want an entertaining exploration of the boundary between sanity and insanity.

There is evidence that lunatics have taken over federal economic policy. Let's look at some of the irrationality.

Ultra Low Interest Rates. The Federal Reserve's ultra low fed funds rate target (and discount rate) are meant to stimulate economic activity. But banks aren't lending because they don't consider anyone creditworthy any more. So interest rates that could slip beneath a snake's belly don't have a stimulative effect. But they severely penalize savers and retirees who depend on interest income. The U.S. needs to boost its savings, to have capital to fund the government's deficits. But the government ensures meager rewards for savers, while taxing those rewards as ordinary income. (By contrast, capital gains, which are scarcer than hens teeth in today's financial markets, are given preferential tax treatment.) Retirees who see the interest on their hard-earned savings evaporate are hardly going to run out to the nearest mall and give the economy a consumption-driven boost. The wealth effect goes into reverse when your investment income dries up. Ultra low interest rates also push down the dollar, which increases the price of oil and gasoline. This must be the push me-pull you kind of stimulus.

Combating Deflation. The federal government is shoving as much borrowed and printed money as possible into the economy to, among other things, reduce the potential for deflation. Deflation, we are told, is bad because consumers will wait for prices to drop before buying, thereby reducing spending. And repayment of debt becomes more burdensome if the borrower must repay with deflated dollars. But these broad propositions overlook the fact that not all deflation is bad. If consumption of a particular item cannot be deferred, deflation is good, because lower prices will stimulate more consumption. For example, it's hard to defer most purchases of food, electricity, and gasoline. If prices of these items fall, that gives consumers more discretionary income for other purchases (or to repay their debts faster). But the Fed's tsunami of liquidity doesn't differentiate between the prices of goods where purchases can be deferred and those that cannot. Thus, all these free-floating dollars could set the stage for serious inflation, and perhaps sooner than we'd think. The recent deflation in gas prices is a darn good thing, and some deflation in food prices would be welcome.

Supporting Asset Prices. Official denials notwithstanding, it's clear that the Bush administration and Congress have acted to support stock prices. The incoming Obama administration is hinting at supporting real estate prices. Government subsidies of this nature inevitably cause misallocation of society's resources. We have invested way too much money in real estate. Much of it was borrowed money, and we are paying a painful price for this misallocation. No lesson has been learned, however, as the Fed, Treasury, Congress and White House all jump whenever the stock market tells them to jump. Government prescribed asset prices will either cost the taxpayers a mint, or provide speculators with undue profits (take a look at federal agricultural price supports, or the time in 1992 when hedge funds smacked down the British pound). The government should focus on providing a safety net for the unemployed and those in need of health insurance; and stimulate economic activity. Let the market set asset prices; that's what the market does well and the government does poorly.

Lack of Change. Too many of the Obama administration's appointees were close the scenes of the crimes leading up to the economic crisis. Their actual or potential involvement in past governmental failures or disappointments casts doubt over their ability to be effective in official positions and in the freshness of their thinking. One form of insane behavior is repetitive self-destructiveness. We want Barack Obama to succeed. This country badly needs a successful President. Repetitive self-destructive policy making isn't conducive to success.

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