The End of the Economist?
The financial panic of 2008 is often blamed on greedy bankers and lax US regulations.
The latter mixed with the former then allowed a mix of dangerous derivatives and misguided policy decisions that nearly undid the global financial system.
At least, that’s how we remember it.
It’s a neat fit to lay the blame on the government and the banks. Yet it was decades of policy decisions before that which contributed to the epic proportion of the financial crisis.
In fact, as Jim points out today, it may have been the rise of the economist in politics that set up the greatest market meltdown in recent memory.
Read on for more.
Until next time,
The End of the Economist?
Jim Rickards, Strategist
As if the Fed didn’t have enough on its plate…it has now been dragged unwillingly into both the currency wars and trade wars raging around the world.
As we know, the Fed’s main jobs are price stability and low unemployment.
That’s the famous ‘dual mandate’ legislated in the Humphrey-Hawkins Act of 1978.
The reality is though, the Fed has one and only one mission, which is to bail out the banking system from time to time when banks are failing due to bad lending, overleverage or failed proprietary trading.
Still, the dual mandate makes a nice talking point for Fed Chair speeches and Congressional testimony.
Two things are clear.
The Fed is not supposed to interfere in currency markets (that’s the US Treasury’s job, although Treasury can use the New York Fed trading desk when it wishes to intervene), and the Fed should not be involved with trade issues at all (that’s the job of the White House and the US Trade Representative).
But market factors are so interconnected today that the Fed can’t keep out of trade and currency fights even if it wants to…
Fed drawn into political storm
Lower interest rates can make the US dollar weaker (unless foreign central banks cut rates even faster than the Fed, in which case the dollar can get stronger).
A weaker US dollar resulting from Fed policy can make US exports more competitive and help the US trade position.
Major trading partners and emerging market economies all watch the Fed to see what they should do with their interest rate policies to help their own export positions.
As a recent article from Reuters explains, the Fed has now been drawn into practically all global economic struggles because of its control over US interest rates, and, indirectly, the value of the US dollar, bonds, stocks and other major asset classes. With Reuters noting:
‘The lesson may apply to central banks in developing nations as well, according to new research presented on Friday that concluded using monetary policy to fight a currency war may ultimately lead to self-inflicted wounds.
‘For developing nations at least, when a central bank like the Fed acts and global capital flows shift, the interest rates needed to keep the local currency from changing value are likely to throw monetary policy out of line with what the local economy needs.
‘Borrowing costs at that point become either too tight and court a slowdown, or too loose and court inflation or excessive borrowing.’1
This predicament is made worse by the fact that the US is in a presidential election cycle.
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The Fed might appear to favour Trump’s re-election by cutting interest rates; a perception it wants to avoid.
Yet, it may have to cut interest rates anyway to avoid a recession and higher unemployment.
The Fed would like to be non-political, but it has been drawn into the eye of a major political storm.
Economists tried to control the economy
Not that long ago, economists were nerdy academics who were consulted on a short list of technical issues, but were otherwise not included in the inner circles of power.
This changed in the mid-1960s when economists claimed they could ‘fine-tune’ the economy with their ‘econometric models’. They couldn’t.
The US suffered four recessions between 1969 and 1981, and stocks moved sideways over that 12-year period.
The 1969 stock market high was not surpassed until 1982.
In the 1970s, President Nixon followed the advice of Milton Friedman to abandon gold and move to floating exchange rates.
This resulted in the worst US inflation (1977–1981) since the end of the First World War.
Persistent failure by economists did not impede their rise to power in the 1980s and 1990s.
The failures of risk management and modern finance led to the tequila crisis (1994), the Russia-LTCM collapse (1998) and the dotcom crash (2000).
Still, the economists marched on.
Didn’t see the crash coming
This ascent was arrested by the 2008 financial crisis.
As this recent article written by The Atlantic describes:
‘Starting in the 1970s, however, economists began to wield extraordinary influence. They persuaded Richard Nixon to abolish the military draft. They brought economics into the courtroom.
‘They took over many of the top posts at regulatory agencies, and they devised cost-benefit tests to ensure that regulations were warranted.
‘To facilitate this testing, economists presumed to set a number on the value of life itself; some of the best passages of [Binyamin] Appelbaum’s fine book describe this subtle revolution.
‘Meanwhile, Fed chairmen were expected to have economic credentials.
‘Soon the noneconomists on the Fed staff were languishing in the metaphorical basement.
‘The rise of economics, Appelbaum writes, “transformed the business of government, the conduct of business, and, as a result, the patterns of everyday life.”’
Economists (by then in positions of power in the White House, Federal Reserve and other central banks) did not see the panic coming, underestimated its impact when it did arrive, and bungled the crisis management by bailing out insolvent banks at the expense of savers and taxpayers.
With The Atlantic adding:
‘The upshot was the whirlwind of the past decade: the greatest financial crash in recent memory, and a crisis of legitimacy in the world’s advanced democracies.
‘After decades in which economists’ influence expanded rapidly, the striking thing about the Trump administration and its foreign analogues is that they have largely dispensed with economic advisers.
‘The United States has lived through the era of corporatism, the era of transactionalism, and the economists’ hour.
‘The intellectual marketplace awaits a fresh approach to the structuring of work and the good society.’2
Today, economists are far more humble in their claims to expertise.
The two most powerful central bankers in the world, Jay Powell at the Fed and Christine Lagarde nominated to head the ECB, are not economists; they are both lawyers. That’s some progress.
The Atlantic poses the questions of whether economists will move back to centre stage or be confined to their ivory towers, as they were until the 1960s.
We should hope for the latter, but beware of the former.
All the best,