30 July 2008

I'm on track--I think like a Harvard prof...

Ken Rogoff (Harvard professor of economics) writes in the Financial Times on July 29:

"The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast...The world has just experienced perhaps the most remarkable boom in modern history."

"...Absent a significant global recession (which will almost certainly lead to a commodity price crash), it will probably take a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels...In the meantime, if all regions attempt to maintain high growth through macroeconomic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future."

"...In the light of the experience of the 1970's, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions."

Some are arguing that we don't have much to worry about; that we're out of the woods now. But a depreciating dollar and continued growth in demand for basic commodities and essential goods as a result of both real supply shock and misguided macroeconomic policy will only make the inflation that ensues that much harder and longer. Stabilizing inflation expectations after such unscrupulous policy decisions will take years, if not up to a decade, making it much harder for the economy to expand when uncertainty about price stability is high. One of the things necessary for the U.S. economy to expand and stay strong is stable prices. But policymakers seem to be abandoning their caution when it comes to inflation these days (except for Dallas Fed President Richard Fisher, as evidenced in his vote to increase the federal funds rate in the June 25 meeting of the FOMC), something that will most likely come back to bite us in the ass. As Mr. Rogoff points out:

"...as goods prices rise, wage pressures will eventually follow. As Carmen Reinhart and I have shown in our research on the history of international financial crises, government in every corner of the world showed themselves perfectly capable of achieving very high rates of inflation long before they had the assistance of modern unions*." (*:See end of post for the research cited)

"...Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to have several years of elevated inflation to help bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on."

We had a good run for a while, but now it's time to let things cool and restructure while we await the next economic boom. But let's not try to keep this thing going forever. It's time to buckle down and deal with reality. Instead of keeping lackluster business' alive and breathing by letting the federal government bail them out, we should let them fail, allowing the lesson to sink in that excessive risk has a cost that eventually gets paid. And instead of maintaining lax regulation on the financial industry, we should beef up oversight and regulations to prevent future occurrences of excessive risk tolerance in exchange for fat profits (and to prevent another future financial crisis). Continued bail outs will increase the federal governments liabilties and drive further devaluation of the dollar. Instead of trying to keep interest rates low (I say trying because that's exactly what is happening; real interest rates aren't responding like they used to with changes in the federal funds rate--> See Paul Krugman's post on this), let's start slowly bringing them back up to encourage less spending, thus reducing pressure on demand for resources and give the world some time to increase supply for essential commodities. I like that way Mr. Rogoff says it:

"For a myriad reasons, both technical and political, financial market regulation is never going to be stringent enough in booms. That is why it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail?"

And it's a bit resonant of one of my previous posts, in the sense that he points out that U.S. has a "growth imperative" that leads to a rationalization of actions like tax rebates, dramatic interest rate cuts and financial institution bail-outs to stimulate demand and growth. He also thinks, as I do, that the good times must end for a while: "...policymakers must refrain from excessively expansionary macroeconomic policy at this juncture and accept the slowdown that must inevitably come at the end of such an incredible boom."

To bring everything to a close, the continued attempts to prevent growth from slowing are utlimately going to make the inevitable crash much worse than it could have been. Mr. Rogoff agrees:

"In policymaker's zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn."
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* This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, NBER Working Paper 13882, March 2008

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