Mon, Aug 27, 2007 - Page 9 News List

People shouldn't suffer because of economic theory

By Melvyn Krauss

The possibility that the European Central Bank (ECB) may raise interest rates in the midst of a financial crisis recalls the great US orator William Jennings Bryant's famous "Cross of Gold" speech in 1896.

Referring to the international gold standard's deflationary bias, Bryan said: "You shall not press down upon the brow of labor a crown of thorns. You shall not crucify mankind upon a cross of gold."

In other words, ordinary people should not be made to suffer for the foibles of policymakers enthralled by some defunct economic theory.

Today, the defunct economic theory is that a rapid shift in preferences -- colorfully called a "reduced appetite for risk" -- is the key reason behind the current sub-prime mortgage and financial crisis.

To avoid future increases in this appetite, policymakers and pundits have focused on the so-called "moral hazard problem:" the "bad guys" must pay for their mistakes, lest they make them again.

One would have expected the modern-day William Jennings Bryans to be warning central bankers not to crucify mankind on a "cross of moral hazard and no-bailouts."

But, surprisingly, the opposite is occurring.

Some on the left, motivated in part by revulsion against financial types who are thought to reap unjustified incomes, have joined forces with conventional economists, whose almost religious belief in their models has blinded them to the harm their dubious economic theory can do to the real economy and the interests of ordinary people. No bailouts can mean no college for the kids -- or, for many, no house.

The key question economists should now be asking is why financial markets are "seizing up" when banks and other financial institutions are flush with liquidity.

The conventional explanation -- a reduced appetite for risk -- is not convincing. The subprime market seems too small to have caused such a broad-based change in risk preference.

A more convincing explanation is that today's crisis, with its unknown dimensions and scope, has so clouded the economic landscape as to freeze market participants in their tracks, so to speak, until things clear up.

That is the fundamental lesson of the important new book Imperfect Knowledge Economics: Exchange Rates and Risk by Roman Frydman and Michael Goldberg. The key to understanding financial markets, especially when they are as unsettled as they have been lately, is not a change in preferences, but inherent imperfection of knowledge and altered expectations concerning the future course of macroeconomic fundamentals.

What policy prescriptions does the "imperfect knowledge" approach imply for the current crisis? The most important one for central bankers is that they should cut interest rates -- and cut them fast -- to re-assure market participants that turmoil in financial markets will not be allowed to affect the real economy.

Judging by its policy reversal, the US Federal Reserve acts as if it were a late convert to the imperfect knowledge hypothesis. Led by Chairman Ben Bernanke, a former leading academic economist, the Fed at first fell into the trap of turning a blind eye to the wider consequences of the subprime mortgage crisis. It injected money into the system, but ruled out interest-rate cuts.

The results of this misguided policy proved so disastrous -- financial markets seized up almost immediately -- that a mere 10 days after its "What, me worry?" message, the Fed made an embarrassing but necessary about-face and lowered the discount rate by 50 basis points. Downward risks to growth had significantly increased, Fed officials explained.

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