Challenge Milton Friedman and his ideas? (source: Bloomberg)
Will this crisis bring more government regulation? Yes.
Will this crisis challenge the core ideas of Chicago school of economics? I don’t think so.
“There are no atheists in foxholes and no ideologues in financial crises“. Get us out of this mess first, then worry about writing economic theories.
Bob Lucas, Nobel laureate at University of Chicago, approves what Bernanke has done and he thinks monetary policy is most effective to fight the current crisis. What the Fed has done is to bypass banks to lend directly to the broader economy.
Bernanke Is the Best Stimulus Right Now
A zero interest rate isn't the last weapon in the Fed arsenal
The Federal Reserve's lowering of interest rates last Tuesday was welcome, but it was also received with skepticism. Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.
It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused. Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending.
There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount — lend against — a wide variety of securities held by a variety of financial institutions. (The addition is to be weighed against September 2007's total outstanding level of reserves of about $50 billion.)
This action has been the boldest exercise of the Fed's lender-of-last-resort function in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue or expand this discounting activity as long as the situation dictates.
Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality" that is very much analogous to the "flight to currency" that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety. Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets. The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession. Adding directly to reserves — the ultimate liquid, safe asset — adds to supply of "quality" and relieves the perceived need to reduce spending.
When the Fed wants to stimulate spending in normal times, it uses reserves to buy Treasury bills in the federal-funds market, reducing the funds' rate. But as the rate nears zero, Treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of "quality" assets.
A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves — or "printing money" — to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector.
This expansion of Fed lending has not violated the constraint that "the" interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months. The yield on short-term governments is now about the same as the yield on cash: zero. But the spreads between governments and privately-issued bonds are large at all maturities. The flight to quality means exactly that many are eager to trade private paper for non-interest bearing (or low-interest bearing) reserves and with the Fed's help they are doing so every day.
Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this. We care about the quantity of its liabilities.
There are many ways to stimulate spending, and many of these methods are now under serious consideration. How could it be otherwise? But monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans. It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues.
Mr. Lucas, a professor of economics at the University of Chicago, received the Nobel Prize in Economic Sciences in 1995.
Summer inflation worry was all gone. Now everybody is worried about deflation, including Bernanke. So why the gold, the hedge of inflation, isn't falling? (Source: WSJ)
Many corners of the market are fearing deflation. So why is it that gold isn't selling off sharply?
As the quintessential hard asset, one that traditionally hedges against rising consumer prices, gold's trajectory these days should be downward. After all, prices for just about every other commodity, from oil to nickel to cotton, have plunged as inflation risks have seemingly abated and as investors increasingly fear deflation.
Yet, gold has largely traded between $750 and $850 an ounce for the last few months, and is up about 8% since the Fed cut interest rates to between 0% and 0.25% last week.
It hasn't been an entirely smooth ride. Gold sank amid panic this fall as investors crowded into the U.S. dollar. And it remains well under its $1,002 close back in March. But the metal hasn't stumbled nearly to the degree many other commodities have. Clearly, deflation worries aren't tugging at gold.
Instead, other factors — historically low U.S. interest rates, U.S. dollar weakness and the longer-term inflationary pressures of the Federal Reserve throwing trillions of dollars at the American economy — "mean the environment is favorable for gold," says Tobias Merath, head of commodity research at Credit Suisse in Singapore.
The Fed's recent actions and words — that it will pursue unconventional stimulus such as buying agency debt, mortgage-backed securities and, potentially, longer-term Treasurys — have pushed Treasurys to unusually low yields.
That development neutralizes a key argument against gold: that gold imposes a holding cost since it generates no interest. Now, the U.S. dollar, measured by short-term T-bill returns, effectively offers no yield either.
And while inflation isn't apparent today, stimulus packages and bailouts mean much more money in the system. That is classically inflationary. Moreover, despite efforts to sop up this liquidity later, the effects of unintended consequences might mean some portion of the trillions added to the Fed's balance sheet are likely to "stick around" to fuel inflation, says Axel Merk, who recently increased gold exposure in his Merk Hard Asset Fund and personal portfolio.
Says Malcolm Southwood, commodities analyst at Goldman Sachs JBWere in Australia, "I'm telling clients that the environment over the next five years is extremely constructive because of the inflationary risks further out."
Near-term gold could still demonstrate some weakness as the last of the panic trade peters out. And if the European Union cuts interest rates, as some expect, that could boost the dollar's value, which could undermine gold. And U.S. and European Central banks could sell gold to raise cash to pay for bailouts, which would be bearish for gold prices. But Mr. Southwood suspects Asian central bankers looking to diversify reserves would grab that supply, seeing the sales as "an alarm signal about the dollar."
And what if deflation does hit? Even that doesn't necessarily spell doom for gold, as some think. During the deflationary Great Depression, "gold preserved its value," says Matt McLennan, a lead manager at First Eagle funds, which runs a gold fund. "It preserved its purchasing power."