Do Fed Officials Read Fed Publications? They Should!

February 13, 2008

It is mindboggling when considering the amount of newly printed money Washington has dumped into our economy in the last ten months or so.  The Federal Reserve, Treasury, and the Congress have poured in over $9 trillion worth of stimulus, loans, stock purchases, and loan guarantee money.  That figure represents about two-thirds of our GDP.  However last night, Treasury Secretary Tim Geithner indicated in an interview on Bloomberg that what has been done so far is “too little too late”.  Thus he proposed a new $2 trillion big bank bailout plan.  The plan coupled with Obama’s stimulus bill will saturate the market with an addition $3 trillion.  The new printing of dollars will bring the total to $12 trillion – if this doesn’t stabilize home prices, increase lending, and create four million jobs then I don’t know what will.

But, the President doesn’t seem convinced all this spending will work.  Speaking in Ft. Myers, Florida, on Tuesday, he stated his belief that his winning a second term in office could depend on whether he can turn the country’s economy around.  The President stated, “If stuff hasn’t worked, if people don’t feel like I’ve led the country in the right direction then you’ll have a new president”.  If history is any guide then chances are likely we will have a new president in 2013.

At the Federal Reserve Bank of Minneapolis, from 2000 to 2007, Timothy Kehoe, Edward Prescott and a team of 24 economists from around the world studied economic depressions that happened in the Twentieth Century.  Instead of focusing on what caused each severe downturn, their study examined government’s reaction to the downturn and the consequences thereof.

First, they looked at the economic experiences of Chile and Mexico in the 1980s.  Both countries suffered from falling international prices for the commodity they exported – copper for Chile and oil for Mexico.  This in turn exposed a weakness in each country’s banking sector.  In 1982, Chile took control of its banks; it liquidated the insolvent ones and reprivatized the solvent ones.  It set up a new regulatory structure which allowed the market to dictate interest rates and allocation of credit to business.  The immediate effect was severe pain, but by 1984 the Chilean economy began to grow and is still the fastest growing in Latin America.

Conversely, Mexico pursued policies which nationalized banks, provided credit at below-market interest rates to some large firms and no credit to others, and provided massive fiscal stimulus schemes to grow employment.  Even though both nations arrived at the same place for the same reasons, it was in how each nation’s government dealt with the crisis that determined their economic futures.  Since 1982, Chile has experienced significant GDP growth while Mexico has languished with a slight GDP growth increase.  See graph on page three:  http://www.minneapolisfed.org/research/SR/SR421.pdf

The researchers also looked at Japan and Finland in the 1990s.  Both countries experienced economic downturns in the early part of that decade.  Japan pursued similar policies to Mexico’s in the previous decade – massive fiscal stimulus, propping up of insolvent banks, and discriminatory credit allowances.  Japan’s economy is still stagnant to this day.

Finland’s response was more like Chile’s.  Its government paid the price of reform and let the market decide the allotment of credit to the private sector.  The Finnish economy has experienced robust growth since.    

From their seven year study, Kehoe and Prescott have concluded that bad government policies cause depressions.  Specifically, they are convinced that it is the “overreaction” by government which “prolongs” and “deepens” economic downturns.  Based on their research, they believe unproductive firms should be liquidated, including banks and auto makers.  Bailouts which prop up unproductive firms do nothing but “depress productivity” further because they take labor and capital away from productive enterprises that would use them more effectively.  Lastly, they have more faith in markets than the government to make better decisions when it comes to resource allocation.

Their findings have been published in the book Great Depressions of the Twentieth Century, published in 2007 by the Federal Reserve Bank of Minneapolis.  The big question is, have Geithner (former chair of the New York Federal Reserve) and Bernanke (current chair of the Federal Reserve Bank) read it?  How can there be such a disconnect between the Fed’s publication and Geithner and Bernanke’s words and actions?  History does repeat itself.  Perhaps if Geithner and Bernanke in 2007 had read the wise analysis of their colleagues, we wouldn’t be repeating history and well on our way to the next great depression.  Kehoe and Prescott would have to agree that $12 trillion is a hell of an overreaction by government.  Thus, we should expect the mother of all depressions.    

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One Response to Do Fed Officials Read Fed Publications? They Should!

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