Will printing money help the economy?

Of course, we side with Brian Doherty...

Will printing money help the economy?
What's the wisdom behind the Fed's recent actions? Doug Henwood and Brian Doherty debate.

December 17, 2008 - LATimes.com

Today's question: Critics say that the Federal Reserve -- which will buy up to $800-billion worth of troubled mortgage and consumer-credit assets -- is effectively printing money to fix the economy. What's the wisdom behind the Fed's actions? Doug Henwood and Brian Doherty debate the consequences of federal monetary policy.

It's better to inflate than deflate.

Point: Doug Henwood

It's not just critics who say the Fed is printing money to fix the economy. That's what it's doing, and I don't see what's wrong with it.

Back in 2002, Federal Reserve Chairman Ben S. Bernanke gave a speech reflecting on what a central bank might do if faced with the threat of deflation -- an extended period of falling prices. Falling prices might sound nice, but over the last century, they've generally accompanied severe economic crises, like Japan in the 1990s or, worse, the U.S in the 1930s. A deflation turning into a depression is a central banker's worst nightmare. And we're at risk for one of those today.

In that speech, Bernanke -- who made his academic reputation by studying the role of bank failures and other financial troubles in propagating the Depression -- said that everything should be done to prevent a deflation from taking hold, and if one took hold, everything should be done to reverse it. Speaking six years ago, Bernanke laid out the framework for what the Fed is doing today -- deep cuts in interest rates, unorthodox purchases of securities (not the short-term U.S. Treasury paper the Fed usually trades in but long-term bonds, mortgage bonds and even private securities) and financing a big fiscal stimulus by printing money. "If we do fall into deflation ... we can take comfort that the logic of the printing press ... must assert itself, and sufficient injections of money will ultimately always reverse a deflation," he said.

For further perspective on current events, we can turn to a classic 1933 paper on debt deflations by economist Irving Fisher. His model boils down to this: Some shock hits the economy, resulting in an increase in pessimism and asset sales. Asset sales drive down prices, leading to more pessimism and distress selling. That results in a shrinkage in the money supply and a decline in velocity (the speed at which money turns over, a function of how quickly people spend). Prices for goods and services fall, hitting profits and raising the real value of debts. Businesses go bust. Managers of surviving firms cut production and employment.

This deepens pessimism, leading those with cash to hoard it. Repeat in a vicious cycle. The point of Bernanke's printing press is to arrest and reverse this process.

Fisher, writing when the New Deal was only months old, noted that FDR's early policies of imposing a bank holiday (after 10,000 had failed) and going off the gold standard quickly reversed the deflation and marked the beginning of an economic recovery. After contracting by 27% between 1929 and 1933, the economy grew 43% from 1933 to 1937.

Sure, printing money sounds awful, but not as bad as watching the unemployment rate hit 25%, as it did in 1933.

Libertarians consider this an interference with the self-adjusting beauties of the free market. Some even argue that the New Deal made the Depression worse, by not allowing the system's excesses to be purged, through some economic equivalent of a high colonic. Bernanke doesn't agree, and I'm glad for that.

Doug Henwood edits the Left Business Observer and does a weekly radio show on WBAI-FM in New York and KPFA-FM in Berkeley.

Runaway inflation would cause far more misery than a bit of deflation.

Counterpoint: Brian Doherty

Deflations can be grim, and inflations can be grim. As a way to help ameliorate -- though not eliminate -- these often damaging fluctuations in currency value, I'm going to speak up for a line of thought I've long been sympathetic to: the hard money school of economics (the Austrian variety is my favorite) which posits that the best way to "manage" the money supply is to remove from political authorities the ability to make more of it willy-nilly.

The most dire eventuality of government's ability to inflate its way out of perceived problems (as I fear Bernanke is gearing up to do today) dwarfs even the difficulties in America in the 1930s or 1990s Japan (more on that in a minute). See the hyperinflations of Germany in the 1920s, Hungary in the 1940s and, more recently, Zimbabwe.

Given Bernanke's firmly stated beliefs, and the fear of the early '30s deflation you mention, we have far more reason to fear inflation out of control than rampant deflation. Inflation out of control means, among other evils, the wiping out of most savings and most Americans seeing their real resources gradually shrink even with apparent monetary gain.

Deflation, especially of the mild variety we might be seeing right now, need not lead to the looping downward spiral of Fisher's model. In the last half of the 19th century, for example, America saw overall price deflation combined with overall healthy economic growth (with some ups and downs along the way). See this data sheet from the St. Louis Federal Reserve Bank on how deflationary episodes can correspond with economic growth and health.

Even if Fed money supply looseness doesn't lead to a repeat of a 1923 Germany horror show, I think we have recent evidence indicating that a Bernanke inflation solution might not save us. Although Doug has elsewhere argued that the problem was Japanese authorities not acting quickly enough, I think the experience of Japan in the 1990s -- where at least 10 attempts at massive fiscal stimulus, lowering interest rates to rock bottom and raising the money supply all failed to propel the nation from recessionary doldrums -- should at least make us wonder if Bernanke's policy is worth the risk.

Yes, deflationary hangover adjustments from years of cheap credit and money growth can be painful, which is why free-market, hard-money types advocate eschewing willy-nilly credit and money growth in the first place. One big worry arising from Bernanke's current intentions is that if we seem hellbent on increasing the quantity of these mysterious paper things to get out of today's mess, those things are going to be worth less -- far less -- even if that inflationary action solves an apparent short-term problem.

And that could hasten the day when the people who lend the U.S. money in the hopes of getting back something that's worth close to what they lent us will stop. Which, as gold goes up and the dollar down, leads us to tomorrow's topic, roughly: How much government debt is too much?

Brian Doherty is a senior editor at Reason magazine and author of "Radicals for Capitalism" and "Gun Control on Trial."

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Europe on the brink of currency crisis meltdown

From the Telegraph:

Europe on the brink of currency crisis meltdown
The crisis in Hungary recalls the heady days of the UK’s expulsion from the ERM.

By Ambrose Evans-Pritchard
Last Updated: 10:52AM GMT 26 Oct 2008

The financial crisis spreading like wildfire across the former Soviet bloc threatens to set off a second and more dangerous banking crisis in Western Europe, tipping the whole Continent into a fully-fledged economic slump.

Currency pegs are being tested to destruction on the fringes of Europe’s monetary union in a traumatic upheaval that recalls the collapse of the Exchange Rate Mechanism in 1992.

“This is the biggest currency crisis the world has ever seen,” said Neil Mellor, a strategist at Bank of New York Mellon.

Experts fear the mayhem may soon trigger a chain reaction within the eurozone itself. The risk is a surge in capital flight from Austria – the country, as it happens, that set off the global banking collapse of May 1931 when Credit-Anstalt went down – and from a string of Club Med countries that rely on foreign funding to cover huge current account deficits.

The latest data from the Bank for International Settlements shows that Western European banks hold almost all the exposure to the emerging market bubble, now busting with spectacular effect.

They account for three-quarters of the total $4.7 trillion £2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom – a sum that vastly exceeds the scale of both the US sub-prime and Alt-A debacles.

Europe has already had its first foretaste of what this may mean. Iceland’s demise has left them nursing likely losses of $74bn (£47bn). The Germans have lost $22bn.

Stephen Jen, currency chief at Morgan Stanley, says the emerging market crash is a vastly underestimated risk. It threatens to become “the second epicentre of the global financial crisis”, this time unfolding in Europe rather than America.

Austria’s bank exposure to emerging markets is equal to 85pc of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia – all now queuing up (with Belarus) for rescue packages from the International Monetary Fund.

Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain. The US figure is just 4pc. America is the staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn) to what was once the US backyard. Hence the growing doubts about the health of Spain’s financial system – already under stress from its own property crash – as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.

Broadly speaking, the US and Japan sat out the emerging market credit boom. The lending spree has been a European play – often using dollar balance sheets, adding another ugly twist as global “deleveraging” causes the dollar to rocket. Nowhere has this been more extreme than in the ex-Soviet bloc.

The region has borrowed $1.6 trillion in dollars, euros, and Swiss francs. A few dare-devil homeowners in Hungary and Latvia took out mortgages in Japanese yen. They have just suffered a 40pc rise in their debt since July. Nobody warned them what happens when the Japanese carry trade goes into brutal reverse, as it does when the cycle turns.

The IMF’s experts drafted a report two years ago – Asia 1996 and Eastern Europe 2006 – Déjà vu all over again? – warning that the region exhibited the most dangerous excesses in the world.

Inexplicably, the text was never published, though underground copies circulated. Little was done to cool credit growth, or to halt the fatal reliance on foreign capital. Last week, the silent authors had their moment of vindication as Eastern Europe went haywire.

Hungary stunned the markets by raising rates 3pc to 11.5pc in a last-ditch attempt to defend the forint’s currency peg in the ERM.

It is just blood in the water for hedge funds sharks, eyeing a long line of currency kills. “The economy is not strong enough to take it, so you know it is unsustainable,” said Simon Derrick, currency strategist at the Bank of New York Mellon.

Romania raised its overnight lending to 900pc to stem capital flight, recalling the near-crazed gestures by Scandinavia’s central banks in the final days of the 1992 ERM crisis – political moves that turned the Nordic banking crisis into a disaster.

Russia too is in the eye of the storm, despite its energy wealth – or because of it. The cost of insuring Russian sovereign debt through credit default swaps (CDS) surged to 1,200 basis points last week, higher than Iceland’s debt before Götterdammerung struck Reykjavik.

The markets no longer believe that the spending structure of the Russian state is viable as oil threatens to plunge below $60 a barrel. The foreign debt of the oligarchs ($530bn) has surpassed the country’s foreign reserves. Some $47bn has to be repaid over the next two months.

Traders are paying close attention as contagion moves from the periphery of the eurozone into the core. They are tracking the yield spreads between Italian and German 10-year bonds, the stress barometer of monetary union.

The spreads reached a post-EMU high of 93 last week. Nobody knows where the snapping point is, but anything above 100 would be viewed as a red alarm. The market took careful note on Friday that Portugal’s biggest banks, Millenium, BPI, and Banco Espirito Santo are preparing to take up the state’s emergency credit guarantees.

Hans Redeker, currency chief at BNP Paribas, says there is an imminent danger that East Europe’s currency pegs will be smashed unless the EU authorities wake up to the full gravity of the threat, and that in turn will trigger a dangerous crisis for EMU itself.

“The system is paralysed, and it is starting to look like Black Wednesday in 1992. I’m afraid this is going to have a very deflationary effect on the economy of Western Europe. It is almost guaranteed that euroland money supply is about to implode,” he said.

A grain of comfort for British readers: UK banks have almost no exposure to the ex-Communist bloc, except in Poland – one of the less vulnerable states.

The threat to Britain lies in emerging Asia, where banks have lent $329bn, almost as much as the Americans and Japanese combined. Whether you realise it or not, your pension fund is sunk in Vietnamese bonds and loans to Indian steel magnates. Didn’t they tell you?

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