Saturday, March 03, 2007


The Deflation Elephant in the Room

It is not easy to be a conservative who believes that out of control credit creation has caused an asset bubble which threatens to send the US into depression. I came of age, economically, in the early 80's reading George Gilder's Wealth and Poverty and arguing for the simple elegance of the Laffer curve. I was and am a true believer in low tax rates being a stimulus to economic grow and to increased tax revenue. On top of this add on the fact that so many leftists have glommed onto the threat of the bubble to detract from anything President Bush touches. (Of course they were no complaints from the lefties when Greenspan and Robert Rubin made the handshake deal to cut the deficit and ramp up the credit creation putting the economy firmly in the hands of the Fed.)

Unfortunately, some of my old heroes have bought into the easy credit path to prosperity. I was watching Kudlow & Co. the day of the glitch and besides the usual cheerleaders was Arthur Laffer following the company line. Even the editorial page of the Wall Street Journal has had nothing but ridicule for the idea that debt poses a danger to the economy. They propose that the savings rate is an antiquated way of measuring what Americans are truly saving.

As a statistic, however, the official "savings rate" is nearly as useless a guide to prosperity as the trade deficit. In the government accounts, what is called the savings rate is literally income less consumption. But the government defines income too narrowly and consumption broadly. For example, "income" doesn't measure capital gains (whether realized or not), the rising value of your home, or even increases in your retirement accounts.

There is a reason that capital gains and increases in the value of your home are not counted as savings. Foremost is that both could be the result of inflation. Asset inflation to be more specific. There no small element of risk in most assets that throw of capital gains and the value of your home might be considered savings but now with home prices rising to levels of unaffordability in so many regions of the country how can anyone reasonable say they can count on the value of their home being their to tap for an emergency in the next few years. Only in a bubble driven economy which has existed for this long can so many ignore risk.

Well much to my surprise I caught a moment of sobriety in the WSJ this past week. I can't say I read them as religiously as I used to so I don't know if this is the first time they have acknowledged that there might be a Fed induced problem but this is the first time I have seen it.

The current problems in the housing credit markets owe a great deal already to the Fed's mistake in keeping monetary policy too easy for too long during the late Greenspan era. We now have to ride them out, and Mr. Bernanke shouldn't make them worse with a panicky, premature easing.

This is momentous because it shows a willingness to consider that Fed policy has been too easy. Something anathema to the likes of Larry Kudlow who still believes the bear market of 2001-2003 was caused by the Fed being to tight. Unfortunately it is far too late to do anything to stop the coming deflation. It will play out but there is a glimmer of hope that the blame will be laid properly, not at the feet of capitalism but firmly on the shoulders of Alan Greenspan and all who ignored the asset bubble while it was expedient.

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