Monday, September 03, 2007

WSJ: Hold the line Bernanke

When was the last time you agreed with a WSJ editorial, of all things? But when they're right they're right.
Except of course for their last paragraph where they call for tax cuts, by which they mean forcing the middle and lower classes to pay an even greater proportion of the taxes that are collected. Of course tax cuts for the middle and lower classes should be enacted and the money raised from those with more than say, $5 million of net income. Would that be fair?
Check out the useful graphs (available on the Web) which I've seen on the net but not the NYTimes which only printed a confused and misleading version. One look at the graph of the price of houses should make clear how perversely asleep were the regulators. It doesn't take a Ph.D. to recognize that something should be done -- as in raising interest rates -- when housing prices go to say 10 times their historical averages.

Wall Street Journal
August 31, 2007
The Song of Bernanke
August 31, 2007; Page A8

And so did a cry of lamentation arise from the multitudes unto Bernanke: Spare us, Oh Lord, from the wrath of subprime.

From the House of Countrywide wailing was heard, from the land of Dodd and Schumer there was gnashing of polls, and from the Kingdoms of Bear, Lehman and Cramer the rending of fine Italian garments: Set your righteous hand, glorious and merciful Fed, against our enemies among the rating agencies, the risk-averse and short-sellers. In your power and majesty, you need only say the word and interest rates shall fall, liquidity like manna shall descend from the skies, and easy credit shall flow once again across the parched and barren land.

Try as we might, we can't find this passage in the Old Testament. But you wouldn't know it from the increasingly desperate pleas for Ben Bernanke and the Federal Reserve to save the economy, if not all of mankind, from the August credit crunch. Judging from the media incantations, you'd think Chairman Bernanke could simply cut the fed funds rate and credit worries would crumble like Jericho.

We think, instead, that Mr. Bernanke has been doing well these last few weeks by resisting this belief in the Fed as Yahweh. The central bank has been doing good work in its role as a financial system plumber, plugging leaks as they spring up, and in reassuring banks that its liquidity window is open. Mr. Bernanke has done especially well to resist being bullied by Wall Street, the homebuilders, automakers and easy-money editorialists into opening the broader credit spigots. When he speaks at the Fed's annual Jackson Hole retreat today, Chairman Bernanke -- who favors transparency -- has a chance to explain how the central bank contributed to the current problems, and why it can't be anyone's savior.

Mr. Bernanke is in part a hostage to the legacy of the Alan Greenspan era, when the Fed seemed to ride to the rescue during every financial crisis. This is the famous "Greenspan put," which is as much legend as reality. The current market and media pleas to Mr. Bernanke are in part an attempt to get the new Fed chief to behave as if it is something of a guarantee. But the Fed doesn't have the same flexibility now, in part because its reckless policy in the early part of this decade helped produce the credit excesses we are now trying to work off.

As Dallas Fed Governor Richard Fisher has candidly acknowledged, the central bank kept interest rates too low for too long. For much if not all of 2003 through 2005, short-term interest rates were below the observed rate of inflation. This is a subsidy for debt creation. And debt certainly was created, flowing into the housing markets and causing a boom in prices out of all historic proportion. The first chart suggests the magnitude of the housing bubble relative to median family income.

The same incentive for debt fed the boom on Wall Street, where creative minds found all sorts of new ways to package and sell mortgage assets. There was nothing corrupt in most of this, and given the low cost of credit it made sense at the time. Everyone loved the boom while it lasted, except that home prices can't increase at 10% to 20% a year forever. The Fed was feeding inflationary expectations that hadn't been seen since the late 1970s. The price of gold is one rough proxy for those expectations, and the second chart suggests the magnitude of its mistake.

It hardly matters, as some claim in defense of the Fed, that officially measured inflation only rose to 3.4% from 1.9% from 2003-2005. What matters is the magnitude of the increase and altered expectations. The U.S. didn't arrive at 13% inflation in a single leap during the 1970s. It got there step by step, as the Fed was called upon again and again to save a sputtering economy with easy credit, and it eventually lost all credibility. That's one risk the Fed faces now as it confronts the lamentations of the bubble boys. A reckless reflation runs the risk of bigger problems down the road if it results in a global loss of confidence in Mr. Bernanke, or in the dollar as a store of value.

The Fed's first obligation isn't to reflate the bubble but is to protect the larger economy and especially price stability. One economic reality today is that the Fed's debt subsidy led to a misallocation of resources into real estate and certain debt instruments that is in the process of being worked off. The losses are real, and someone will have to pay them. Housing prices will fall in some markets for some time to come. There is no joy in saying so, but this is what happens when credit is no longer subsidized and markets change their risk assessments.

One question looking forward is how much the housing recession will affect consumer spending and thus the overall economy. The same commentators who said only two months ago that all was well now say that housing will tank everything if the Fed does nothing. Yet the economy entered this period on an upswing, as yesterday's upward revision of second quarter GDP to 4%, from the preliminary 3.4%, shows. Corporate profits rose smartly, and last week's industrial production numbers were good. Weekly jobless claims have been climbing, but the overall labor market has been healthy.

The Fed may well have to act if the economy does begin to stumble. But if that happens, the Fed isn't the only or even the best policy lever. Fiscal policy is also available, which means the Bush Administration and Congress should be considering another tax cut. A tax cut could revive incentives for risk-taking among those feeling burned by the housing fallout. The federal deficit is heading down to 1% of GDP, and nothing would be worse for tax receipts than a recession.

We realize tax cutting is taboo in today's Washington, but if the Presidential candidates aren't considering a tax cut proposal, they should be. The entreaties of Wall Street notwithstanding, the Federal Reserve is no miracle worker.

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