Thursday, November 12, 2009

It's the Economy!!

I attended a Harvard breakfast meeting this morning. Bill Hass and Shep Pryor, who are co-authors with Arthur Laffer on the book The Private Equity Edge. The talk was very interesting and I immediately drove to Borders in Deerfield and picked up an autographed copy.

I ran into trouble right away. In the preface the authors say:

“Our interdisciplinary value-based study and perspective on corporate strategy, corporate profits, political leadership, and the macroeconomic factors over the last 50 years should be of great interest to all. Political leaders can especially benefit from the perspective of corporate decision makers on the impact of government intervention and their unintended consequences on the wealth and risk of the nation.

For example, we have recently learned a lesson on the importance of using the right goals and metrics in managing the monetary base of the U.S. monetary system. While the Fed was attempting to keep inflation under control it failed to maintain the monetary base needed to keep the global economy growing. Although there is plenty of blame to go around, the Fed mismanaged the monetary base and promoted a credit crunch that led to a major economic crisis.”

This is an interesting take on the cause of the economic crisis. You don’t often hear people say the cause was a credit crunch. Rather, the cause is often attributed to just the opposite, a credit glut that cause financial institutions to create very risky loans.

They included this graph to show the drop in monetary supply when Ben Bernanke succeeded Alan Greenspan on February 1st 2006.

The rate of growth in the money supply is considered to be a leading economic indicator because the Fed tends to increase the money supply in an attempt to counteract an anticipated slowing of economic growth. The interesting thing here is that during the years 1999-2006 the fed under Greenspan grew the monetary base by an average annual rate of 6.6%. During those same years real GDP grew at only 2.7%. This is a big sustained gap. Where did all that excess money go? Into riskier and riskier loans, and riskier and riskier derivative financial instruments.

It seems to me that the suggestion that Bernanke caused the financial crisis is a bit disingenuous. Allowing bad credits to soak up the excess money supply under Greenspan was as much to blame, and probably more so. After Bernanke took over the two rates tracked each other very closely. The problem was already in place. Continuing the old monetary policy would have just delayed the inevitable.

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