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Brian Wesbury, writing in today’s Wall Street Journal [2], offers excellent reasons why the anxiety over the current state of the economy is overblown. Here are some key paragraphs:
Beneath every dollar of counterparty risk, and every
swap, derivative, or leveraged loan, is a real economic asset. The only
way credit troubles could spread to take down the entire system is if
the economy completely fell apart. And that only happens when
government policy goes wildly off track.
In the Great Depression, the Federal Reserve allowed
the money supply to collapse by 25%, which caused a dangerous
deflation. In turn, this deflation caused massive bank failures. The
Smoot-Hawley Tariff Act of 1930, Herbert Hoover’s tax hike passed in
1932, and then FDR’s alphabet soup of new agencies, regulations and
anticapitalist government activity provided the coup de grace. No
wonder thousands of banks failed and unemployment ballooned to 20%.
But in the U.S. today, the Federal Reserve is
extremely accommodative. Not only is the federal funds rate well below
the trend in nominal GDP growth, but real interest rates are low and
getting lower. In addition, gold prices have almost quadrupled during
the past six years, while the consumer price index rose more than 4%
last year.
These monetary conditions are not conducive to a
collapse of credit markets and financial institutions. Any financial
institution that goes under does so because of its own mistakes, not
because money was too tight. Trade protectionism has not become a
reality, and while tax hikes have been proposed, Congress has been
unable to push one through.
Which brings up an interesting thought: If the U.S.
financial system is really as fragile as many people say, why should we
go to such lengths to save it? If a $100 billion, or even $300 billion,
loss in the subprime loan world can cause the entire system to
collapse, maybe we should be working hard to build a better system that
is stronger and more reliable.
Pumping massive amounts of liquidity into the economy
and pumping up government spending by giving money away through rebates
may create more problems than it helps to solve. Kicking the can down
the road is not a positive policy.
The irony is almost too much to take. Yesterday
everyone was worried about excessive consumer spending, a lack of
saving, exploding debt levels, and federal budget deficits. Today, our
government is doing just about everything in its power to help
consumers borrow more at low rates, while it is running up the budget
deficit to get people to spend more. This is the tyranny of the urgent
in an election year and it’s the development that investors should
really worry about. It reads just like the 1970s.
The good news is that the U.S. financial system is not
as fragile as many pundits suggest. Nor is the economy showing anything
other than normal signs of stress. Assuming a 1.5% annualized growth
rate in the fourth quarter, real GDP will have grown by 2.8% in the
year ending in December 2007 and 3.2% in the second half during the
height of the so-called credit crunch. Initial unemployment claims, a
very consistent canary in the coal mine for recessions, are nowhere
near a level of concern.
I would add that one major cause of the collapse of so many U.S. banks during the Great Depression was the fact that branch banking in the U.S. was highly restricted. This restriction on branch banking (1) denied banks the opportunity to diversify their operations geographically. (See, for example, this paper by my GMU colleague Carlos Ramirez. [3]) (Also, Canada, which had no restrictions on bank branching, suffered, I think, only one bank failure during the Depression.), and/or (2) reduces competition among banks, thus making them less efficient [4].