Martin Wolf Defends the Fed

Normally, I have the highest regard for Martin Wolf, the Financial Times’ lead economics writer. He is forthright, data-driven, articulate, sober, and insightful.

However, I take issue with his current article, “The Federal Reserve must prolong the party,” and see its failings as symptomatic of the state of economics.

In brief, Wolf argues that the problems the Fed is facing are due as much (his tone suggests more) to the global savings glut than to Greenspan having served as a bubble enabler:

Has the Federal Reserve been a serial bubble-blower? Or has it been responding to exceptional macroeconomic conditions? Not surprisingly, the implication of Ben Bernanke’s celebrated speech on the global “savings glut” implies the second view. Yet his self-exculpatory perspective is far from universally shared. So who is right? My answer is both. The Fed can indeed be accused of being a serial bubble-blower. But this is not because it has been managed by incompetents. It is because it has been managed by competent people responding to exceptional circumstances.

The savings glut is a palpable reality….Since global long-term real interest rates have been modest, the argument that profligate US spending has been crowding out spending elsewhere is not credible. It is more plausible that excess savings elsewhere have been “crowding in” US spending….

What has all this meant for policy? The answer is simple: the Fed has, willy nilly, pursued a monetary policy capable of inducing a huge and unprecedented financial deficit among US households. This has, not coincidentally, also meant a rapid rise in household indebtedness. The vehicle through which this policy has worked has been asset-backed borrowing and lending, the activity that has so spectacularly derailed this year. To put the point more broadly, monetary policy normally works via asset markets. In the latest cycle, the most affected sector has been households, the vehicle asset market has been housing and transmission has been via securitised lending.

Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter. Assume that the US remains a huge net importer of capital. Assume, too, that US business sees no reason to invest more than its retained profits. Assume, finally, that the government pursues a modestly prudent fiscal policy. Then US households must spend more than their incomes. If they fail to do so, the economy will plunge into recession unless something else changes elsewhere.

This is why the Fed is sure to cut interest rates if today’s crisis seems likely to reduce the supply of credit (as surely it will). Would that work or might the Fed find itself “pushing on a string”, as the Bank of Japan did so painfully in the 1990s and early 2000s? A good guess is that the policy would work. But if it did not, there would be only two ways out: a huge fiscal expansion in the US or a huge reduction in the US current account deficit. The former looks undesirable and the latter inconceivable.

Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?

I have a nagging feeling that economists and regulators do not fully understand our current environment. The situation described by the catchphrase “global imbalances” is outside any historical pattern. So are other elements of our present financial system: the predominant role of what New York Fed president called “market-based credit” (as opposed to the old fashioned sort that was intermediated via the banking system); the near-universal use of mark-to-market approaches for asset valuation among financial institutions (even for long-term holdings); the scale and importance of derivative trading; the velocity of trading; the value of financial assets relative to the real economy.

Individually, these elements may appear understandable (although I am not certain anyone has a good grip the full implications of the large role of derivatives). But these factors are operating simultaneously, creating a Brave New World of finance that increasingly drives the real economy. Thus, economists’ confidence in their knowledge of what is at work strikes me as eerily similar to the quants’ belief in their models. Despite the fact that these models blew up spectacularly last week, their creators’ faith remains intact even though that faith seems badly misplaced. Can the same be true for the likes of Wolf and Bernanke?

Now if I were the only person nursing these suspicions, I’d be inclined to dismiss them. But others who possess better economics and market credentials than mine harbor similar worries. Consider these remarks from Henry Kaufman:

What is missing today is a comprehensive framework that pulls together financial-market behavior and economic behavior. The study of economics and finance has become highly specialized and compartmentalized within the academic community. This is, of course, another reflection of the increasingly specialized demands of our complex civilization. Regrettably, today’s economics and finance professions have produced no minds with the analytical reach of Adam Smith, John Maynard Keynes or Milton Friedman.

Note that the trio that Kaufman cites weren’t merely brilliant economists. Each was the author of a new paradigm that guided government policies successfully, until further economic evolution brought new tools to the fore. Yet no one seems ready or able to do the fundamental thinking needed to move us forward.

But crises often bring their own solution, and perhaps a bright young thinker is coming to grips with our current conundrum. We can only hope.