The "Long Run" is a Sequence of "Short Runs"
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 22nd October 2009.
Even within the ranks of analysts who have some understanding of the problems caused by fiscal and monetary "stimulus", it is commonly held that an economic/financial crisis requires "liquidity injections" and government intervention in order to overcome the immediate obstacle. It is acknowledged that the 'assistance' provided by the government and the central bank will have negative consequences in the long run, but it is generally argued that the long-term negatives can be dealt with after the dust settles.
The commonly-held belief that "stimulus" (monetary injections and increased government spending) is justifiable in the face of extreme conditions is actually a big part of the problem, because such attempts to alleviate short-term pressure chip away at the structure of the economy and sow the seeds of an even greater downturn or crisis. By way of further explanation we will now quickly review the sequence of events that led to the collapse of 2007-2009, beginning with the 1998 financial crisis.
1. The failure of a large hedge fund (LTCM) combined with a Russian debt default between July and October of 1998 prompted Federal Reserve intervention to stabilise the financial system, fostering the belief that certain US financial institutions were too big to fail and that the Fed would always be there to add liquidity if things went awry (the infamous "Greenspan Put"). This effectively pumped more monetary fuel into a stock market that was already in bubble territory. Part of the intervention involved getting Government Sponsored Enterprises (Fannie and Freddie) to channel hundreds of billions of dollars into the residential mortgage market. The housing boom was thus set in motion.
2. Fear that the Y2K Bug would cause havoc prompted the Fed to inject a huge amount of money into the financial system during the second half of 1999, adding even more air to the burgeoning stock market bubble.
3. During the first half of 2001 the Fed furiously cut interest rates and began ramping up the money supply in an effort to mitigate the knock-on effects of the bursting of the stock market bubble. This gave the nascent housing boom a figurative 'shot in the arm'.
4. Fear that the terrorist attacks of September-2001 would cause the financial system to 'freeze up' and worsen the economic recession prompted the Fed to dramatically accelerate the pace at which it was providing monetary support. This increased the size of the housing boom.
5. During 2001-2002, highly respected commentators on economic policy (for example, Paul McCulley and Paul Krugman) called for the Fed to create a housing bubble to alleviate the effects of the bursting stock market bubble. At around the same time, a Fed Governor (the current Fed Chairman) made it clear that the Fed could/would create whatever amount of new money was necessary to ensure that prices continued to rise. A steeper upward trend in property prices and a mortgage-related lending/borrowing binge ensued.
6. Due to the general perception that deflation was a short-term threat, monetary policy remained extremely accommodative until 2005. This was despite the fact that equities and commodities had been rallying strongly since early-2003, and that a housing boom had been underway for several years. Consequently, McCulley and Krugman got their wish and the housing market entered bubble territory. A sequence of actions justified by the perceived need to fix short-term problems had thus set the stage for a crisis that dwarfed its predecessors.
7. Proving that nothing had been learnt from prior mistakes, the 'big daddy' crisis of 2007-2009 was met with similar policy responses to those that gave birth to the crisis, only on a much grander scale. Also proving that nothing had been learnt from history, there was almost universal acceptance that policymakers needed to take such steps to get us past the immediate threat. As usual, the popular line of thinking was: "We need to put aside long-term consequences for now and do something -- anything -- to make things better in the short-term".
Some analysts who applauded the interventionist measures taken to alleviate short-term pressure are now saying that it's time for central banks and governments to step back and let the 'free market' do its thing. However, it doesn't work like that. The reality is that the pressure-alleviating/stability-engendering measures have created an economy that is even more unstable than the one that tanked suddenly and 'unexpectedly' during 2007-2008. This means that some time (probably no more than 6 months) after the central bank begins to pull back on the monetary reins, there will be another crisis that 'justifies' still more inflation and intervention.
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