Monday, November 24, 2008

[Latest Endogenous Liquidity Index: -65.9%; Latest Global Dollar Liquidity measure: +40.1%]

I'm a big fan of the Market Price Approach to monetary policy, as outlined in 1996 by Manuel Johnson and Robert Keleher (*). Largely relying on the work of Swedish economist Knut Wicksell, their recipe is deceptively simple: watch a trifecta of market-based indicators — the shape of yield curve, commodity prices and exchange rates. If the yield curve gets steeper and steeper, and commodity prices increase sharply, and the currency falls apart, then a central bank has an obvious inflation problem on its hands. [By the way, I'm collecting data to build a Market-Price-Approach Liquidity Index!]

Right now, we're in a crisis — and the blame game is in full swing. Some people seem to think that the 1% fed funds rate of 2003 was the key culprit (in terms of the housing boom and the subsequent collapse). Although I tend to symphatize with that view, I've been around long enough to know that bubbles are incredibly complex phenomena. Along with monetary policy considerations, many additional factors intervene: innovation waves, structural economic shifts, and plain old human nature with its inseparable greed and fear elements. Enough said — here's some intellectual ammo on the subject of rates and bubbles:

[1] Fed vice-chairman Donald Kohn. To his credit, Mr. Kohn does not dodge the bullet. "How might these monetary policy actions have fueled speculation?", he asks, rhetorically. His answer: maybe; but then again, it's more complex than that. "In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the Great Moderation back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions". [Donald L. Kohn: "Monetary Policy and Asset Prices Revisited", Federal Reserve Board]

[2] Jim Grant. The Financial Times'' John Authers reviews Mr. Market Miscalculates by James Grant: "As early as 2004, he wrote about how the 1 per cent Fed Funds rate, with which the Greenspan Fed battled the perceived threat of deflation, had “transformed the borrowing patterns of the clientele of the northeast region of Washington Mutual”. WaMu has now passed into history as the biggest US bank failure on record". With such juicy passages in mind, Mr. Authers concludes that Grant's volume "may well be the most perceptive book on the current financial crisis yet published". [John Authers: "Profit from prophesies of doom", Financial Times] [Grant's Interest Rate Observer]

[3] Gerald P. O'Driscoll Jr. This is by far the most Wicksellian piece of all: "With a commodity standard in place, the government would also have price signals that would alert it to the formation of a bubble. Why? Because the price of the commodity would be continuously traded in spot and futures markets. Excessive easing by the Fed would be signaled by rising prices for the commodity. In recent years, Fed officials have claimed that they cannot know when an asset bubble is developing. With a commodity standard in place, it would be clear to anyone watching spot markets whether a bubble is forming. What's more, if Fed officials ignored price signals, outflows of commodity reserves would force them to act against the bubble". Very interesting, although I doubt that such a mechanism would completely "avoid bubbles". [Gerald P. O'Driscoll Jr.: "To Prevent Bubbles, Restrain the Fed", The Wall Street Journal]

[4] Richard Duncan. The author of The Dollar Crisis: Causes, Consequences, Cures is at it again: "Between unnaturally depressed interest rates and the buying spree by Fannie and Freddie, US property prices surged. The US housing bubble followed the ill-fated Nasdaq bubble. However, the inflation of the US housing market was one bubble too far. When it imploded, the global financial system was hurled into crisis, leaving the 21st century version of Anglo-American financial capitalism discredited". [Richard Duncan: "Bring back link between gold and dollar", Financial Times]

(*) Manuel Johnson & Robert Keleher. Monetary Policy: A Market Price Approach (Westport, Connecticut: Quorum Books, 1996).

1 comment:

JWG said...

Poor management and overtly risk intolerant individuals have given rise to the situation we see ourselves in.