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Grant the Great

January 28, 2008
James Grant, Jeff Tucker's favorite New York Timer, tries to understand "[h]ow...the supposedly "contained" subprime mortgage problem metastasize[d] into a global financial panic." Given this article's appearance on Mises.org, is it surprising that Grant places blame on the Federal Reserve? In a speech before he became Chairman of the Fed, Ben Bernanke talked about a "Great Moderation" that the Fed had engineered. Greenspan in all his wisdom would be able to steer the economy into a permanent prosperity. Right...
...it was actually the Great Complacency that Mr. Bernanke had put his finger on. In finance, to borrow from the economist Hyman Minsky, nothing is so destabilizing as stability. The paradox is easily explained. Profit-seeking people will take more financial risk when they believe the coast is clear. By taking bigger chances, however, they unwittingly make the world unsafe all over again. Anxious people don't ordinarily get in over their heads; it's the confident ones who do. And nothing builds confidence like the belief that a greater power has conquered the business cycle and laid inflation low. In such happy circumstances, a calculating human will take out a bigger mortgage, build a bigger hedge fund or attempt a gaudier corporate buyout. That is, he or she will borrow more money, or, as they say on Wall Street, lay on more leverage.
This is what the Fed does. They try to manufacture economic prosperity by artificially distorting the market with low interest rates; the consequence of this action is the inducing of unwise investments. Eventually, entrepreneurs realize this error and liquidate the unprofitable investments; this leads to a retraction--the "bust" of the cycle. So the way to cure the recession is to minimize the role of the government:
If stability leads to instability, it follows that instability will eventually restore tranquillity. But first must come the tallying up of the errors, misjudgments and outright criminality that blossomed during the Great Moderation. Mr. Bernanke, in an attempt to limit the damage and hasten the healing, is likely to keep the Fed's rate low -- lower, even, than the measured inflation rate.
Unfortunately, this will lead to even greater problems:
To lubricate the machinery of lending and borrowing, Mr. Bernanke is likely to make dollars increasingly plentiful. The trouble is that, while the Fed is America's central bank, the dollar is the world's currency. It lines the vaults of central banks of America's creditors, especially the up-and-coming states of Asia and the oil-soaked principalities of the Middle East. Such institutions hold dollars by choice, and not a few of them chafe at the greenback's steady loss of purchasing power. For some, Tuesday's hasty rate cut might be the last straw. As just about nobody predicted the present troubles, humility is what becomes today's forecaster the most. So I will offer up a humble forecast. Inflation will, at length, make its way up from the bottom of the Fed's worry list to the very top. Not for years has it seemed to matter that the dollar is only a piece of paper. But, before very long, that homely fact will push itself back to the fore.
What a pleasant surprise to read such clear thinking in such a muddled newspaper. Who knows, maybe we'll hear a coherent sentence in tonight's State of the Union address.

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