Congressman
Ron Paul:Bubble economy cannot keep going indefinitely Posted:
Fri, Jan 25 2008. 12:18 AM IST
Ben Bernanke is now coming to realize that a
bubble economy cannot keep going indefinitely
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.
But very rarely do we ask why we need these frequent injections
by central banks. Even more fundamental and less asked are
the queries about what causes these bubbles in the first place
and why we have these recessions. If these questions had been
asked, then the absurdity of the solutions proposed would
be obvious.
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.