Some of the headlines from last week’s Federal Reserve conference sounded like they were written in the 1930’s when the Hoover Administration encouraged liquidation of assets and banks as a way to fix the economy. Willem Buiter, a former official of the Bank of England and European Bank for Reconstruction and Development, sounded like Andrew Mellon when he criticized the Fed’s policies last week (Andrew Mellon was Herbert Hoover’s Secretary of the Treasury). Buiter argues that the Fed is rescuing Wall Street at the expense of Main Street and forgets that Main Street and Wall Street have a co-dependent relationship. The last time Washington took the co-dependency for granted the Great Depression resulted.
Buiter thinks that the Fed is sacrificing inflation, creating moral hazard and hurting systemic integrity. Just like Andrew Mellon and his “liquidationist” theories, Buiter’s prescription fixing the system will result in destruction of money supply and GDP. Buiter is correct that the system needs to be fixed and rules enforced, however monetary policy is the wrong policy level for this task.
Like Mellon, Buiter makes several fatal analytical errors. Three are highlighted below.
Error #1 – “Output contractions can be reversed easily through expansionary policies.“
When Buiter writes “reversed easily” I doubt if he has considered the economic calamity of the 1930’s. Despite the efforts of smart and conscientious public officials, it took a combination of fascism, genocide, the destruction of several countries and tens of millions dead (i.e., WWII) to get the U.S. and Europe out of the Depression. Buiter writes 144 pages criticizing the Fed and other central bankers, but in a single sentence is able to dismiss 20 years of human suffering as “reversed easily”. He forgets that the Great Depression is widely regarded as having been a Fed creation when it didn’t respond appropriately to the destruction of the monetary stock caused by a real estate, Wall Street and banking crisis.
Error #2 –Non-bank financials can take up the slack of a failing banking sector.
Buiter is in error when he compares the financial system of the 1920’s and 1930’s to the current financial system and concludes that a collapse of the banking sector won’t kill the economy. He believes that unlike the 1930’s the growth of the non-bank financial services sector provides some sort of a safety net to the economy that can take the place of banks. Unfortunately, Buiter’s analysis of how the crisis unfolded (which is actually pretty good) contradicts his assumption that catastrophic losses in the banks won’t cause catastrophic losses in the rest of the economy.
By the way, I doubt if Buiter understands where non-bank financial companies deposit their money, how they transaction their business or who acts as an intermediary to get cash to non-bank financial companies. In all three cases it is banks. Non-bank financial companies cannot survive without banks and cannot thrive without a healthy banking sector.
Error #3 – Crashing home prices just aren’t as important as the Fed thinks.
Buiter badly underestimates the effect of falling house prices. With myopic focus, he focuses on short term consumption implications of falling house prices and the immediate household wealth effect and misses longer term implications of housing stock destruction.
While Buiter agrees falling house prices are bad for construction (and by implication builders and the companies that support builders), he ignores the effect of changes in consumption patterns and potential population migration (which has many precedents in the last 100 years). Other affected industries that Buiter ignores include appliance and building materials manufacturers, mortgage and real estate professionals (lawyers, appraisers, brokers, bankers, etc), utilities, transportation, schools, government, health care, retail distribution, communications and other ancillary infrastructure. In short, almost everyone is hurt or will have a relative who is displaced if the housing contraction continues. The Fed isn’t overreacting.
It’s a good thing that Fed officials have studied history and know that Buiter has provided a step by step instruction book on “how to” create a depression. The Fed can’t afford to get policy wrong and must err on the side of economic stability and not in favor of “teaching the bums a lesson”.
While I am as angry as everyone else (and have been a constant and consistent advocate of enforcement of current rules, regulations and criminal laws which the Bush Administration doesn’t do) monetary policy isn’t the proper policy lever for regulatory enforcement. The SEC, Justice Department, OCC, FDIC, state banking regulators, state attorney generals and Fed (in its role as the primary regulator of bank holding companies but not in its role as central banker) need to enforce current laws and regulations and punish individuals and companies that violate these rules.
Let’s not repeat the mistakes of the Hoover Administration and destroy confidence in ourselves and our economy. Buiter work should be studied as an example of what not to do and how not to do it.