Three monetary pessimists

As I argued in a recent post it is important for Australia to anticipate the likely success of US Federal Reserve moves to avoid a long and severe US recession. These three monetary economists are pessimistic and believe recession is a sure thing and that it will be long and severe. This suggests that commodity price pressures currently driving Australia’s terms of trade as well as local inflation will moderate the US economy weakens. To state the obvious it also means that Australia’s RBA must exert caution with respect to future interest rate hikes lest it induce a local recession here. Indeed the need to be flexible about possibilities for reversing interest rate movements might become apparent over the past year.

Thus although I have argued that the RBA are correct in placing heavy weight on limiting inflation and on maintain credibility for doing so (see here) I take the following pessimistic views seriously.

1. Nobel Prize winning economist Edmund S. Phelps takes a pessimistic view of control possibilities in a modern economy. He rejects the possibility of fine-tuning using monetary ‘financial engineering’ based on standard risk analysis as conceit. He foresees higher US interest rates and higher unemployment for wealth effect reasons – current monetary policies will only have short-term effectiveness. I agree completely – I am disgusted with the way contemporary macroeconomists trot out ‘natural rates of unemployment’ as guides as to whether the economy should be expanded or contracted. As Phelps notes the US natural rate will be higher now than in the past because of financially-induced long-term job destruction in the US residential investment sector. The natural rate idea is so volatile that it is not a useful guide to thinking about macroeconomic policy. Australia’s RBA said last year they don’t use the idea in their policy analyses and that seems sensible to me.

2. Gloomy Paul Krugman also believes that US monetary policy will fail and anticipates a long and deep US recession. It is not that the increasingly ‘desperate’ (Krugman’s word) Federal Reserve is not doing a lot – it is just that the scale of the US woes is so vast. The Fed is buying $400 billion worth of insecure bonds backed by mortgages – this is half of its available funds. To Krugman the current US difficulties look like becoming one of history’s great financial crises with the Fed bailing out the banks but the banks still being unwilling to lend. He seems these monetary woes as the major task of the next US administration. Ugly economics will create ugly politics.

3. David Roche completes the triumvirate of monetary pessimists. Hedge funds and other NDFI (non-deposit taking financial institutions) are now being hit by the credit-crunch. Roche says some strong things:

‘Creating a lot of liquidity does not resolve an issue of solvency, which is now the driver of credit contraction. All the Fed will achieve is a dollar that will be further debased and inflation that will be higher. It cannot stop the process of deleveraging and asset price decline’.

‘Credit contraction translates through the financial system into a reduction in available credit for the non-financial corporate sector, and thus into reduced investment and growth in the real economy. The size of that contraction can be estimated from the leverage ratios of the financial sector and their impact on real GDP growth.

We estimate that nonfinancial corporate debt ultimately will have to shrink by 11%-12%. This will generate a decline of five percentage points of real U.S. GDP growth and push the U.S. into recession. Europe's real GDP growth will contract by two percentage points.

Globally, total credit losses of $1.4 trillion will cause a contraction in world GDP of 2.5 percentage points, or half the current rate of global growth. So the global economy will become a gray, dull world of semi-recession and sticky inflation that will last a long time’.

Meanwhile there is value in trying to shut the gate even if the horse has bolted.