Tuesday, January 22, 2008

That 70s Show

Is macroeconomics up to the job? This subdiscipline is one of the least helpful in the entire field, even as it is one of the most mathematically rigorous. The newspapers are full of accounts of the inability of looser monetary policy by the Federal Reserve to this point to keep the U.S. economy unraveling from the housing mess. Its attempts are vivid in the chart below, showing the monetary aggregate known as MZM, defined as “M2 less small-denomination time deposits plus institutional money funds.”



Since early 2006 monetary policy has been unusually aggressive, at a rate only duplicated in 2001 (marked by the asterisk of 9/11) and, very briefly, 1983. So far, financial firms continue to announce bigger losses and economic growth continues to slow. The models in widest use predict otherwise, and Chairman Bernanke, a first-rate macroeconomist at Princeton, knows everything the profession has to say about monetary policy.

We have seen this movie before. In the 1970s central banks worldwide attempted to fight major economic shocks involving the restriction of oil supply with monetary loosening. What they got for their trouble was stagflation – a combination of rapidly rising prices and weak or negative economic growth that had to be finally fought with a dramatic monetary tightening, and a severe recession, in the early 1980s.

The lesson many of us drew then, and from 1929, was that real shocks have to be allowed to have real consequences. The decision by OPEC countries to capitalize on their control of oil contracts (which they cannot do anymore because of changes in the way oil is bought and sold) pushed a significant increase in an important productive factor through the economy, and the Fed responded the way the textbooks told it to, causing inflation that was wrongly attributed to the rise in price of a single (though important) resource, which in isolation shouldn’t cause comprehensive price increases. The oil shock changed production possibilities for a huge variety of countries, and the way to accommodate it was to accept that the adjustment to these altered possibilities – letting companies discover new ways to produce their goods and services with less oil, and encouraging other companies to go out and find more oil – would be painful rather than try to accommodate it through encouraging more lending.

That is where we are now too. The popping of the housing bubble, like the oil price shock, is a real but far from catastrophic event (one that, as an aside, made housing available to people who would otherwise be unable to own). The idea that encouraging lending in order to cancel out the accumulated mistakes from the invention of new mortgage instruments (which are unavoidable with any innovation and offset by gains to consumers) cures what ails the economy seems misplaced. By hiding the consequences of accumulating errors, we are asking for trouble. A real binge requires that we endure the real hangover.

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