Tuesday, April 28, 2009

Steve Hanke on the Fed's Policies

Steve Hanke makes the case that the Fed's misreading of the deflationary pressures in the early-to-mid 2000s caused it to overreact at the time:
One of our problems is the Fed's preoccupation with the risk of deflation. Fixated on this risk in 2002 and 2003, Greenspan pumped out dollars, cutting the Fed funds rate down to 1%. The easy credit boom continued, inflating asset prices...

What the Fed has failed to realize is that most deflations are good ones, not bad ones. During the last two centuries there have been many deflations throughout the world. Almost all of them have been good ones precipitated by technological innovation, rising productivity, global capital flows and sustained economic growth. If farm mechanization cuts the price of wheat, you get a rising living standard. This is good.

Instead of lowering interest rates seven years ago, the Fed should have raised them. This would have blunted the credit boom that led to the bubble. The most visible excess was a buildup in debt relative to GDP and a deterioration of debt quality. Combined government, corporate and household debt is now 250% of annual GDP, double what it was a generation ago. A lot of the debt on both corporate assets and houses is junk. It can be repaid only by refinancing on the back of ever higher asset prices.

As readers of this blog know, I take a similar view on the deflationary pressures at that time. However, I have also argued there were a number of factors that came together--not just loose monetary policy--to create the perfect financial storm. Still, a good look at the evidence indicates the Fed's approach was highly distortionary at the time.

1 comment:

  1. Federal Reserve was fixated in this decade on the construct of "core inflation" which as one wit has put it, is a measure of inflation that strips out all those things whose price has increased. And of course, Bernanke was haunted by the Japan debacle of the 1990s, which he interpreted as showing the dangers of deflation

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