Stagfaltion on the Way?

Wolfgang Munchau in the FT this morning. I don't really agree with the way in which Wolfgang is framing this, but it is where the argument is at now, and needs to be taken seriously. This is here really so I can find it easily at some point in the future.


No single tactic will beat the subprime crisis

By Wolfgang Munchau

Published: December 9 2007 19:46 | Last updated: December 9 2007 19:46

The subprime crisis is a massive macroeconomic shock in need of a determined policy response. But what kind? It will probably not require a symmetrical response across countries and policy instruments but a more targeted strategy.

The US and the UK, for example, should respond harder than the eurozone and Asia, where the recession probability is much lower. While I never believed in decoupling – the theory spun by exuberant investment bankers that the rest of the world could happily grow when the US was in recession – this is an asymmetric crisis nevertheless.

If you live in a credit-addicted, English-speaking country with a large financial centre, you are more likely to be in trouble.

Nor should central banks, regulators and fiscal authorities open all the policy valves at the same time. The correct response is to use fiscal and regulatory policy aggressively – and monetary policy judiciously. In fact, there was some evidence last week that we are moving in that direction.

The European Central Bank was right in signalling a possible rise in interest rates next year, given prevailing inflationary pressures there. The US Treasury was also right when it came up with a scheme to bail out distressed subprime borrowers by freezing interest payments.

The only fault I could find with the US scheme is that it may not be sufficient – that the US government needs to do more to help mitigate the spillover from housing to the real economy.

The scheme, as it stands now, will not do anything to prevent a sharp economic downturn – but it might just help prevent a downturn becoming a depression. But even in the US, where there is a risk of an outright recession, a monetary over-reaction would be a serious mistake.

One reason is that monetary policy may not be as effective as regulatory and fiscal policy. For monetary policy to be able to bail out distressed borrowers would take cuts in interest rates of the order of some 200 to 300 basis points. And that would only work for those borrowers that can refinance immediately.

It is far better to bail out the distressed mortgage holders directly, if necessary through subsidies. The US has led the way, and Germany and Italy are also discussing relief plans.

Another important reason is the rise in global inflation. This is why Japan’s descent into deflation in the early 1990s offers fewer lessons than some people may think.

While it is true that in the past central banks often made the mistake of under-reacting, rather than over-reacting, this is not a generic lesson of financial crises. The early 1990s was a period of global disinflation. The Japanese asset price crash resulted in deflation and policymakers were in denial at the time.

That is surely not the case now. Global inflation is rising. Globalisation has entered a phase where it no longer just supplies us with cheap goods, but in addition creates large and rising demand for resources with supply constraints, such as oil, food and logistics. Another reason is that the period of wage deflation in western economies may also be coming to an end.

If we are unlucky, we might even end up with stagflation. If, as some commentators have urged, we use monetary policy too aggressively, we risk turning a credit squeeze into a wider financial crisis.

Higher inflation would, of course, help ease the immediate credit crisis as it shifts wealth from lenders to creditors. But it would bring on another, probably much bigger, crisis as investors would then start to desert the US bond market.

The last thing the world economy needs right now is a global bond market crash and an ensuing rise in real interest rates.

Central banks are therefore best advised to focus narrowly on price stability. Of course, a central bank also has responsibility to ensure financial stability, but this should not be confused with bailing out insolvent banks. In fact, it would probably be very healthy for the global financial system if some of those reckless mortgage lenders were allowed to go bankrupt.

A central bank’s role should be confined to providing ample liquidity to the markets through its regular money market operations. This is not at all in conflict with its price stability objective. Why should a central bank not be able to raise interest rates and increase its liquidity provisions at the same time? These two instruments serve different purposes.

Nor is an inflation-targeting approach at a time like this necessarily bad for economic growth.

A pure price stability strategy, if applied persistently and symmetrically, surely offers insurance against deflation and depression, just as it offers insurance against inflation and overheating. If inflationary expectations were to fall below the target, the central bank would still have plenty of time to act vigorously to bring expectations back in line with the target.

It is difficult to make the case at this point that the Federal Reserve is in any danger of undershooting its inflation target.

So if the Fed were to cut interest rates this week, it would be sending out the message that it is ready to let inflationary expectations rise. Even if the Fed goes down that road, the Europeans should walk the other way. I am now more optimistic than before that they will.