White Schools Bernanke on Basic Economics

William White – former head BIS economist, currently chair of the OECD’s Economic and Development Review Committee – is again schooling Ben Bernanke on economic fundamentals.

In an article published in the December-January OECD Observer, White wrote:

The proliferation of financial markets and the relative decline of intermediated credit in recent years have turned the focus to underlying systemic questions. Indeed, we now know that surface indicators of good financial health can be seriously misleading. If market participants are hit by the same shocks, are similarly vulnerable and react similarly as well, the implications for the financial system as a whole and the real economy it underpins can be devastating.

So, financial stability is necessary. However, similar to the earlier failure of price stability to deliver macroeconomic stability, financial stability is also not sufficient to achieve that objective. While “booms” similar to the one we had lived through since the 1990s are ultimately driven by an excess of credit, the imbalances to which they give rise go well beyond unjustified asset price increases and a potentially weakened financial sector. One particular contributor to the severity of the “bust” is debt. In fact, in Japan through the 1990s and beyond, it was not the weakened banking sector that forestalled recovery, but the efforts of the Japanese corporate sector to reduce debt after the excesses of the 1980s. A similar challenge may now be in store for the US, UK and a number of other countries, as consumers and businesses reflect on the state of their balance sheets.

But even this broader set of balance sheet effects fails to account fully for the imbalances generated by excessive credit growth. Perhaps most important is a misallocation of real resources, which then weighs heavily on the economy during the subsequent downturn. In a number of economies, not least the US, the combination of consumption and housing investment rose to unprecedented levels as a proportion of GDP. In China, there was a corresponding upsurge in capital investment. These two developments combined suggest that Asia is now all geared up to produce export goods that the traditional purchasers can no longer afford to buy. And to add to the difficulties ahead, it seems clear that, during the boom, there was a buildup of excess global capacity in a whole range of industries–cars and trucks, banking, wholesale distribution, construction and steel, among many others.

It will take a significant amount of time for the underlying resources (labour and capital) to be either written off or shifted into more profitable and sustainable endeavours. During that time, aggregate production potential will be diminished and structural unemployment will rise. Credit-driven “boom and bust” cycles touch all parts of the economy.

If it is not obvious that White is saying that Bernanke (and most other central bankers) are using inaccurate economic theories, and that we need to learn about the danger of bubbles from Austrian economics, listen to what White recently said at a talk at India’s central bank:

  • Everyone knows that excessive credit was at the heart of the “big mess” we’re in
  • The Fed has set up a straw man against the argument that central banks should act to moderate bubbles while they are being blown. Specifically, Bernanke says that you can’t lean against asset prices, because it’s not clear how to measure asset price bubbles or which asset prices to target
  • But the proper question is whether we lean against the credit bubble itself and its underlying symptoms. Specifically, if credit is the underlying problem, it manifests itself in various imbalances in asset prices, crazy spending patterns like we’ve seen in the U.S., or crazy investing patterns as we’ve seen in China. That’s easy to spot
  • Economists have no insight into the effect of the unprecedented monetary easing measures recently undertaken
  • The Fed says that it is always possible to clean up a bubble after it bursts, because it worked in the past (in 1987, 1991, 1997- 1998, and 2001-2003). But underneath it all, there is a “growing headwind of debt”. This works for a while, but then it won’t work forever.
  • Economists have to learn that things work differently than we’ve been taught. The ideas that the economy is self-stabilizing and follows rational expectations are wrong
  • Economists and central banks need to incorporate Austrian economic theory on supply side economics

White slammed the Fed in 2008 for blowing bubbles and then “using gimmicks and palliatives” which “will only make things worse”:

In a pointed attack on the US Federal Reserve, it said central banks would not find it easy to “clean up” once property bubbles have burst…

Nor does it exonerate the watchdogs. “How could such a huge shadow banking system emerge without provoking clear statements of official concern?”

“The fundamental cause of today’s emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in the advanced industrial countries have been unusually low,” he said.

The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning…

“Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off.

“To deny this through the use of gimmicks and palliatives will only make things worse in the end,” he said.

For background, see this, this, this, this , this, this and this.

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