Monday, August 25, 2008

Tyler Cowen: Finding the mess behind the mess

Economics Professor Tyler Cowen, of George Mason University in the US, writes an op-ed for the NY Times on the US banking crisis.

His diagnosis: "The fundamental problem in the American economy is that, for years, people treated rising asset prices as a substitute for personal savings."

The need to save more sharpens a number of interrelated secondary problems. First, America is aging. More people than ever are entering the years when they stop saving and start spending their nest eggs. That means the transition to higher-than-expected savings may be drawn out and painful.

The second problem is that the American economy is enduring a credit crisis, with many banks trying to raise more capital and make fewer loans. Savings are good for the economy when they lead to investment, but there is no guarantee that financial institutions will be allocating capital efficiently.

The third problem is that lower consumer spending will require the American economy to make some shifts. That may mean fewer Starbucks and fewer new homes but more tractor production for export to foreign markets. In the long run, shifting some consumption to investment is probably beneficial to the economy; in the short run it means job losses and costly readjustments.

In addition, there are still excess homes on the market, and housing prices need to fall further. Of course, such price declines can make banks less solvent and thus worsen the credit crisis. And politicians would like to moderate this fall in prices, again prolonging the adjustment process.

His prescription:
What should policy makers do? One path that is likely to prove counterproductive is further fiscal stimulus in the form of tax rebates. Such stimulus can raise consumer spending and bolster the economy in the short run, but it works — if it works at all — only by pushing consumers to spend rather than to save. It merely postpones needed adjustments by providing a grab bag of goodies at exactly the wrong time.

Excessive bank regulation is another danger. To be sure, the regulatory structure for financial institutions failed in the current crisis, and change is in order. But we shouldn’t reform in a way that will discourage bank lending and weaken the tie between savings and investment. Banks are already allergic to very risky mortgages — probably excessively so — and we shouldn’t overreact by punishing them for past mistakes.

In other words, regulatory reform needs to be forward-looking rather than focused on penance. Given that politics often revolves around assigning blame, it’s not obvious that we will succeed in this task.

Emerging from the current slowdown isn’t just a matter of political will or smart central banking. If the recipe for success requires smooth adjustment into new growth sectors, more savings from disposable income, cleaning up the housing mess, well-functioning energy markets, and more effective financial intermediation — all in the right combinations and in the right sequences — neither the government nor the Federal Reserve can control this process. The Fed can add regulatory and monetary clarity, but there isn’t any magic bullet. Beware of anyone who tells you there is.

The Japanese failed to break out of their recession quickly because they didn’t promptly close down or clean up their problem banks. So far, the Fed and other regulators show no signs of making this mistake; they have been vigilant in resolving crises as they occur. But that’s not enough to guarantee a successful transition. The American economy will be tested for its deftness — and the test will be difficult precisely because there isn’t a single enemy on which to focus.

HAVE you ever tried to undo a bunch of tangled wires or cords? If you don’t pull on the right wires in the right order, the mess becomes worse. If you pull too hard, the whole thing can break. But if your first pulls are good ones, the untangling becomes easier with each move.

This is allegedly a blog about religion, so here's the mandatory religion bit: the "regulatory reform needs to be forward-looking rather than focused on penance" bit is linked to the Christian principle of turn the other cheek, applied to public policy.

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