Tuesday, January 29, 2008

Stimaholics Anonymous

What a strange recession hysteria we've been experiencing the last month or so. Everyone seems to have forgotten what just happened in the housing market. And it's a failure to understand what a bubble is and what to do about it. The Federal Reserve now has a disturbing decade-and-a-half record of stoking financial bubbles with too-loose monetary policy and ignoring the key truth about bubbles:

The bigger a bubble is, the bigger the collapse afterwards.
The more frenzy at the top, the bigger the mess to clean up afterwards.

With memories of the Great Inflation of the 70s still fresh, the Fed reacted reasonably after the 1987 stock market crash (a result of a sudden change in currency values and interest rates). But its reaction to the late 1994 recession scare was bad: it suddenly flooded the world with dollars and didn't stop until a few years later. The Fed's reaction to the 1997-98 Latin American-Asian crisis was materially implicated in the final phase of the 1996-2000 stock bubble. Its reaction to the 2001 recession (the mildest on record) was to keep the cheap credit spigot wide open long after it needed to be, helping to fuel a classic asset bubble in housing.

There are few signs of a recession in the offing, apart from the media's relentless and ignorant shrieking. All signs point to, if anything, inflation, not deflation and recession. The prices of gold and other commodities have risen by factors of two or three in the last few years. Deflation means a currency gaining in value, not losing (like now). Unemployment is low, below five percent. The big bump in the growth and job numbers happened in September. Jobless claims fell last month. How does that add up to a recession? *

Could it be the real problem is that two sectors of the economy, sectors with high visibility in the media - housing and finance - just drilled a hole in the ground, even though the rest of the economy is doing well? And didn't the housing bubble just suck people into buying houses who couldn't afford it? After all, a classic sign of a bubble is people buying assets just because they feel they can sell them at a higher price to someone else later. That sort of mania induces people to take foolish risks, and it described the US housing market from late 2002 until early 2007. And home ownership rates did rise to historic highs, well above the roughly 60% mark that is the historical average - even while housing prices soared far beyond anything justifiable in terms of building costs or affordability.

The Fed should continue to help larger and more solvent institutions bail out smaller and weaker ones, encouraging the liquidation of bad debt, etc. And by the way, that is exactly what the Fed was forced to do, in the end, in 1990-92 and again in 2001-02, after the "stimulus" drug had lost its effect. The Fed will be doing the same in two or three years, when the real recession arrives, ending the current economic expansion that started in late 2001. But by then, the presidential election of 2008 will be over. Influencing that election with a fantasy "economy" and a fantasy "recession" is the mainstream media's real game here.
* Recall the definition: two consecutive quarters (six months straight) of contraction in a nation's economic output.

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