Wednesday, April 02, 2008

What is the value-added?

What is the value-added produced in this city? Alan Greenspan asked his wife during a visit to Venice

What a wonderful question Alan Greenspan asked his wife. It's a pity he didn't honestly ask that question of the institution he led. What is the value-added of the Federal Reserve?

According to the Fed's web site, the Fed's primary responsibility is the formulation (an interesting choice of words, given that, at least during Greenspan's tenure, there was no formula that anyone other than himself could divine, see Alan Blinder) of monetary policy.

One key aspect of correctly setting monetary policy, it seems to me, is the ability to understand the economic forces acting on the US economy, and the effects and intents of those policies- not in some idealized sense but in the real world. On that front I give the Fed an "F" and cite two recent issues: 1) the fear of deflation which led the Fed to lower and maintain rates at levels not seen since the US was the creditor to the world 2) faith in the view that a soft landing had the same cleansing effect as a recession.

Greenspan describes his fear of deflation in The Age of Turbulence: I found it [the possibility that the US might enter a deflationary spiral a la Japan] to be a very unsettling issue. In modern economies, whose chronic headache is inflation, deflation is a rare disease. After all, the United States was no longer on a gold standard. I couldn't conceive of deflation occurring under a fiat money standard.

Sadly, for us, he didn't let his inability to conceive of deflation in a fiat money system stand in the way of acting as if such was possible.

I find the apparently generally accepted view that Japan spent a decade caught in a deflationary spiral a bit odd. According to Japan's Statistics Bureau, the CPI index in Japan fell from a peak of 104.1 in Oct. of 98 to a low of 99.7 in Feb. of 06. A 4% decline in the CPI over 8 years seems more like price stability than a deflationary spiral to me. I suspect the US population would love to have experienced such a decline over the past few years.

A classic example of a deflationary spiral, and one the current Fed Chairman studied exhaustively, is the US experience from 1929 to 1933. During that time period the CPI fell (based on annual data from the BLS) 31%- just under 8 times Japan's 4% decline. Deflationary spiral in Japan, I think not.

A bigger error, in my view, is the notion that the US operated under the same rules, or was subject to the same forces that Japan did and was.

Japan, unlike the US, is not the issuer of the world's reserve currency. Their economy operates within the US$ system. Moreover, Japan has been a chronic external surplus nation, again, unlike the US. Their decades of external surpluses should have (and did) act to strengthen their currency- perhaps one could wonder why, under those conditions, and given Japan's reluctance to allow Yen appreciation within the international system of exchange, Japan didn't really deflate. But Greenspan already answered that, there is no gold standard, therefore, and thus far, deflation remains a rare disease.

Moving from the, in my view, failure to grasp the economic forces acting on the US, let's consider the faith in the cleansing power of the soft landing, recalling William McChesney Martin's famous quote that The Federal Reserve's job is to take away the punch bowl just when the party gets going.

Note that Mr. Martin didn't say that the Fed's job was to dilute the punch in the punch bowl, or switch from punch to beer- i.e. generate a soft landing from a night of drinking- but to take the punch bowl away. Once the punch bowl is removed partiers begin to sober up and the hang-over is soon to set in. And it's the hang-over, which, assuming the punch bowl was removed at the right time, will not be too onerous, will remind partiers of the dangers of too much alcohol, or in this case, too much credit.

But Greenspan seemed to prefer the "hair of the dog that bit you" in the form of a "soft landing." As he wrote: For decades, analysts had wondered whether the dynamics of the business cycle ruled out the possibility of a "soft landing" for the economy- a cyclical slowdown without the job losses and uncertainty of a recession. Ah yes, that's what we need, a way to stop nascent alcoholics from feeling the effects of a hang-over.

Hang-overs, returning to Mr. Martin's metaphor, are like recessions. They are the entirely predictable responses to over-indulgence. But, according to Greenspan, hang-overs are nonrational. To wit: Recessions are tricky to forecast because they are driven in part by nonrational behavior.

Silly me, I thought one of the premises of the capitalist system was the view that investors acted rationally. Recessions, it seems to me, are entirely rational responses to imbalances. Expectations of permanent prosperity, which implies a lack of Schumpeter's creative destruction, are nonrational. Heck, such expectations are downright anti-capitalist.

Where's Senator McCarthy when you need him?

Venice, Greenspan writes he realized, is the antithesis of creative destruction, presumably because it looks much like it did when traders unloaded silks and spices from the Orient.

The Venetians didn't embrace creative destruction, and neither does the Fed. To be fair, the Fed is all for the creative part, but we never seem to get around to the destruction- the cleansing- the clearing away of the old when it proves to not be of use- like the bloated financial sector in the US economy, or the institutions that are supposed to regulate it.

So I ask again, what is the value-added of the Federal Reserve?