What Type of Monetary Policy Can We Expect in the Future? 8 comments
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Given that debates on how to fix the financial crisis have become the conversation du jour, now seems like an appropriate time to re-visit various monetary theories to see what works. So here goes:
Keynesian. John Maynard Keynes is the father of contemporary macroeconomics. I would consider this to be a rather negative claim, given that Keynesian policies are at the heart of our current crisis. According to Keynes, deficit spending is not a problem, and the government should use it when necessary to stimulate the economy. Traditional Keynesian economists are not concerned with price inflation, because they argue that prices will not rise above aggregate demand (i.e. prices will not rise above what people are willing to pay for them). Stagflation is precisely the term for the scenario in which prices begin to rise beyond aggregate demand; witness Zimbabwe, and to a lesser extent, the United States in the late '70s and in 2007.
Regrettably, we still see Keynesian solutions being offered to Keynesian problems. US President-elect Barack Obama has stated that deficit spending should not be feared, and needs to be embraced in the short-term to boost the economy.
Friedmanites. Milton Friedman is not too different from Keynes; the only real difference the most significant difference is that Friedman advocates legislative bodies like Congress regulate the money supply via an agreed upon formula, rather than an independent central bank unbound by formulas. The assumption implicit in this school of economics, though, is that a proper formula can be devised, and that a political body can manage it appropriately without the threat of overwhelming corruption.
Supply-siders. Led by Arthur Laffer and Charles Kadlec, supply-siders argue for watching commodity prices, and then tinkering with the money supply to keep commodity prices stable. In a way, this is similar to the policies championed by Paul Volcker, Federal Reserve chairman during the late '70s. Gold prices were rising dramatically, and Volcker raised interest rates to effectively contract the money supply, strengthen the US dollar, and bring gold prices back down.
Austrians. The Austrian school of economics calls for commodity-backed money. This means that government's job is simply to ensure that each currency certificate can be redeemed for a specific commodity -- typically a precious metal like gold or silver -- and that it is government's role to define the terms of convertibility. The money supply is thus determined by the availability of a commodity. Should the market need to expand the money supply, demand for commodity production will grow. Thus the money supply is regulated by market forces.
What Type of Monetary Policy Can We Expect -- And How to Trade It
I am a strong proponent of the Austrian school of economics, and believe it will result in the most sound monetary system, upon which free market capitalism can best survive and flourish. Though the Fed is pushing interest rates to zero, should the US dollar give back the gains it made in 2008 and should the US government have difficulty finding buyers of its debt at such low rates in a globally weak economy, the result may be the need to raise interest rates sharply, thus bringing about a return to supply-side ideas and Volcker's policies in the '70s. This would be a bearish argument for gold -- just as we saw gold fall in price after Volcker's Fed raised rates.
Ultimately, though, I think Keynesianism is still the dominant ideology. The ideal result of this would be prolonged deflation, as seen in Japan, though as I've stated before, my larger concern is that this will result in sharp currency devaluation, as seen in Argentina.
Trade accordingly!
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This article has 8 comments:
Be careful discussing falling gold prices. You're sure to raise the ire of some. :)
Just a matter of time till this house of cards fails miserably. Fortunatly if we fail in the US I believe all paper money in the world fails so we wont go it alone in my humble opinion.
But, that's exactly the way the system works. Money is debt, and debt grows and grows until it is impossible to pay it back. Then, the system crashes under it's own weight.
This system is not an American phenomenon, it's been around for centuries before American was even conceived. But, we Americans hastened the collapse through immense liquidity generated in the derivative markets. Regardless, collapse will come, sooner or later.
The system will reboot and everything will fall into equilibrium. Then it will start again. Debt will grow and grow until the next crash. And this phenomenon is not just happening in the US. The EU is under the same threat. So is every nation on the fractional banking system. It's just a matter of time.
So, you may be right. If the dollar fails, so might the other majors. They are also fiat, and all fiat currencies fail. Best just to let it happen and pick up the pieces. Maybe try a new banking system.
First, The Fed will keep the (dead) banking system on life support and will not let it fail. Injecting liquidity will almost certainly lead to inflation, in the medium term. But, we are entering a deflationary period, and we need to inflate our way out of it. Unless anyone has a better idea.
We will most likely retain our fractional banking system, despite calls for getting off a fiat currency and abolishing the Fed. But that's okay. By the time housing prices bottom out, taking a mortgage for $75,000 will not generate nearly as much liquidity as a half million dollar mortgage would. Less money will be created in the US and probably in all other currencies, too.
Second, there will (or better be) tighter controls on the derivative markets. We will not be allowed to create massive debt ratios which have us teetering on the brink of depression today. And there will likely be limits on the issuance of debt. Imagine that, the Fed back in control of the money supply. (BTW, Federal Reserve is an oxymoron. I wouldn't mind it if we actually Federalized the Federal Reserve Bank.)
Third, once bitten twice shy. The money making process will be severely cut back, as it should be. Banks will no longer loan with reckless abandon, at least until history is forgotten. I bet we will see the end of large credit limits, possibly the end of 0% down financing in the auto and (most certainly) the housing markets. Housing prices should continue to fall for some time on lessened demand. Especially when one must produce an actual down payment with money that doesn't exist.
Fourth, deleveraging. The whole world is deleveraging back to a level that might just be sustainable. I expect deleveraging to carry on for at least 2 years.
All of this speaks to a vast reduction in the money supply, globally. Even though all nations are inflating right now. And if Helicopter Ben is true to his word, he should be fighting inflation with the same aggressiveness he induced it. You can bet the ECB will fight inflation, too.
So, in sum. I believe (at least today) we will skirt a depression and enter a prolonged period of deep recession...two years, give or take. Our money supply will fall back to a fraction of it's current level on reduced global liquidity including the carry trade. Then it will stay there and be controlled more tightly by the Fed and the government. Credit will be much tighter in the future, and the world will settle into a period of slower, more sustainable growth.
China will just have to be happy with single digit growth in the coming decade or so. Oh, and the dollar will strengthen over this time frame and retain it's status as a reserve currency. But, not without volatility, of course. And it will be a painful correction for everyone.
But, you asked what type of monetary policy (we) see in the future. This is my best estimation on how we will restore confidence in our banking system, our economy, and our currency.