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Business News/ Opinion / Online-views/  Postponing the necessary
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Postponing the necessary

Postponing the necessary

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When Ben Bernanke cut the Fed funds rate on Tuesday by 75 basis points, to 3.5%, the markets responded positively. Financial commentators who had previously stated that Bernanke was an academic and did not understand markets (such as Jim Cramer of CNBC), are now likely to aver their opinions of a new decisive Fed and a return to the “Goldilocks Economy".

It was Alan Greenspan who had earlier perfected the interest rate game by slashing them at every hint of trouble (the 1987 crash, the savings and loans crisis, the LTCM collapse, dot-com bubble burst, 9/11, etc). However, what Greenspan did was to merely “throw money at problems" in the form of inflation, i.e., expansion of credit. For inexplicable reasons, even the bond vigilantes who quite correctly tracked money supply to measure inflation during the 1970s, meekly subjected their judgement to the official claims of benign inflation during the Greenspan era.

Let me start with the dreaded “R" first: Recession is essentially a way for Mr Market to clear out the excesses built in an economy. The excesses are caused either due to a legitimate, but one-time economic boom (e.g., Olympics in Barcelona boosted the economy for a few years leading up to the event) or due to just excessive credit creation (dot-com boom, tulip mania, housing bubbles). In either situation, there is over investment in certain sector(s) of the economy. Recessions are a way to deflate mal-investments.

But just as the boom is accompanied by prosperity, the bust comes with a price tag that isn’t pleasant. When currencies were on the gold standard, the excesses were limited as we would have zero inflation by definition and in any case, there was little that incumbent governments could do to postpone the recession. But, the current fiat currency system, where there is no limit to the amount of money that can be issued, is a boon for an incumbent politician who would like to postpone (under the guise of preventing) a recession.

So, when Mr Market tries to deflate a bubble, the tendency is to pump more money, usually under the pretext of a Keynesian solution for slackening demand, to stimulate the economy. This usually leads to another round of misallocations and, with every passing year, we need increasing amounts of credit to prevent the bubble deflating.

How long can an economy keep the bubble going? Fairly long, as Greenspan demonstrated; but not indefinitely, as Bernanke is now coming to realize. Bernanke in 2004 termed the period under Greenspan “The Great Moderation" as he believed (incorrectly, though) that economic cycles had been tempered. He is now recognizing the fact that the moderation isn’t so great after all as underneath the economy is a massive credit bubble that is in the early stages of deflating.

It should thus be recognized that the solution to a bubble, which is essentially an output of inflation, is to just deflate the same. The subsequent pain that an economy undergoes is merely the medicine for the disease of the earlier mal-investments. When we try to postpone the bubble’s bursting by supplying more credit, all we end up doing is to create a bigger bubble with even more dire consequences from the eventual burst. We saw that with Greenspan, who managed a near- seamless transition from the dot-com bubble to the housing bubble by holding down the Fed funds rate at 1% for an extended period of time.

What is Bernanke trying to achieve by cutting the Fed funds rate this time around? In making credit cheaper, he is trying to boost consumer spending and hence the US economy.

As I have explained above, this is aimed at merely postponing the recession that would arise from the bursting of the housing bubble by creating another bubble. Only this time, and quite unlike the dot-com burst during Greenspan’s tenure, there are no more new bubbles to inflate. And, as history has shown repeatedly, once the process of deflation (in the inflated sector) sets in, the only way to prevent declining asset values would be through the mechanism of hyperinflation.

Ron Paul, Republican Party presidential candidate, summed up the issue when he asked Bernanke during a recent Joint Economic Committee meeting on the housing bubble: “We don’t talk about how we got here, but how we are going to patch it up…the housing bubble has been deflating and spreading and yet, nobody asks where does it come from?...and the advice usually given is inflate the currency or debase the currency. They do not say that, but they merely say lower the interest rates…but the only way you can lower interest rates is by increasing the money supply. I see this as the problem we don’t want to talk about…the bubbles occur because we have these mal-investments and the creation of new money from thin air… So, how in the world can we expect to solve the problems of inflation, i.e. an increase in the supply of money, with more inflation?".

Quite expectedly, Bernanke never answered the question. And I hope this article will help readers answer it for themselves.

(Shanmuganathan N. is director of Benchmark Advisory Services. Comments are welcome at theirview@livemint.com)

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Published: 25 Jan 2008, 12:18 AM IST
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