The Sunshine Report

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.