The Great Debate

-James Saft is a Reuters columnist. The opinions expressed are his own-

A dilemma at the heart of the response to the financial crisis is that the antidote to so many ills actually causes the symptoms to worsen.

Take for examples bank capital levels and the chaos surrounding home mortgage foreclosures.

Both issues are the fruit of the same tree: the desire to do things quickly, cheaply and with minimal safeguards.
And both, if you want to fix them, are probably going to slow the economy and lower asset prices in the short term.

So over the long term, paradoxically, the economy will slow and asset values fall anyway.

Being in possession of a hammer and sighting a nail, Governor of the Bank of England Mervyn King put it bluntly on Monday: “Of all the many ways of organizing banking, the worst is the one we have today.”

In 1987, UK Prime Minister Margaret Thatcher whipped up a firestorm of criticism from her opponents on the left when she told a magazine reporter that “there is no such thing as society”, only individual men and women, and families.

The interpretation of those comments remains fiercely controversial. From the context it is not certain the prime minister was clear what she was trying to say.

But according to one interpretation the prime minister was encouraging her listeners to look beyond the impersonal aggregate of “society” to the individuals behind it.

Chairman Ben Bernanke’s Fed is beset by demons of its own design.

Terrified by memories of the 1930s and Japan’s more recent experience in 1990s and 2000s, the academics who now dominate the Federal Open Market Committee display a hyperactive compulsion to tinker with monetary policy in a bid to solve all the problems besetting the U.S. economy.

But if inflation is always and everywhere a monetary phenomenon, as Milton Friedman argued, Fed policy has a smaller role in solving real-economy problems such as a gaping trade deficit, moribund housing market, sluggish growth and joblessness.

Expectations of another substantial round of quantitative easing (QE2) have gone too far for the Fed to pull back now. The Fed must press ahead or risk a massive, disorderly correction across all asset classes (bonds, equities, commodities and currencies).

QE2 — a second round of quantitative easing — means that soon the U.S., Japan and Britain will all be busily exporting their deflation, raising the question: Just how much pain can the euro zone take?

If by November we have three of the largest economies printing money and buying up their own debt, the outcome — in fact the intention — will be to drive their currencies lower against their trading partners, opening new international markets for their goods and, by raising the price of imported goods, fighting deflation before its debilitating psychology can take hold.

That is the plan, at any rate, and, unless something else happens, it will force the euro up against all major currencies, including, as it is tied to the dollar, the Chinese yuan. The euro has risen about 9.5 percent against the dollar in the past month, a trend that ultimately will murder European exporters and its stock market.

While “decoupled” is not the same as “immune”, look for growth and investment performance in emerging markets to be better than in the sclerotic developed world.

In the short term emerging markets will be free riders as the U.S. launches the second round of quantitative easing. A portion of the stimulus generated by “QE2″ will inevitably leak cross border, while the risks of the gambit will fall almost entirely on the U.S. and on dollar-denominated assets.

QE2 is designed to work in two ways: to stimulate investment by making it cheaper to borrow money and to lift consumption by boosting asset prices.

The American Enterprise Institute is hosting a panel with Nouriel Roubini and Reuters contributor Chris Whalen on “living in the post-bubble world: what’s next?” It is being livestreamed today from 2pm – 4pm ET. You can watch the video of it here:

From AEI’s website:

Americans are living in the wake of the great credit bubble of the twenty-first century. They have experienced the crisis of its collapse, massive increases in government intervention and debt, and now more uncertainty. What’s next? Are we in for a long slog, or will the economy rebound? What will happen to housing prices, mortgage defaults, commercial real estate, the banking system, and post-bubble Europe? Will we have defaults on sovereign debt? Deflation? How big will the Fed’s balance sheet get? What steps should be taken now? These and related questions will be discussed by our panel of economic and financial experts.

The debate is moderated by AEI fellow and former president and chief executive officer of the Federal Home Loan Bank of Chicago Alex J. Pollock. Other panelists are:

If the global currency war was a baseball game, they would have to invoke the “slaughter rule” and send China home the winner.

Motivations and consequences aside, China is so adroit in melding diplomacy, jawboning and action to keep the value of its currency low that you have to feel something approaching compassion for its plodding adversaries from the U.S., Europe and Japan.

China’s latest well played move is its pledge to use some of its massive foreign currency reserves to support poor Greece, which the markets widely believe will default some fine day, European Union support or not.

“It’s like the American dream in reverse.” That’s how President Barack Obama, ten days after taking office last year, described the plight of Americans hit by the faltering economy. His catchy description fell short — the dream has turned into a nightmare for tens of millions.

So much so that an opinion poll this week showed that 43 percent of those surveyed thought that “the American Dream” is a thing of the past. It “once held true” but no longer does. Only half the country believes the dream “still exists,” according to the poll, commissioned by ABC News and Yahoo against a background of dismal statistics on growing poverty, inequality, unemployment, and Americans without health insurance.

Before turning to the gloomy numbers, a brief detour to the meaning of the phrase “the American Dream,” long a familiar part of the U.S. (and international) lexicon.  The survey defined it as “if you work hard, you get ahead.” That’s neat shorthand for the concept that the American social, economic and political system makes success possible for everyone.

It may be about as fun as having a tooth pulled, but cutting very high levels of debt in an economy is more of a process than a short, sharp event.

That means that for economies like that of the United States, which has private debt equal to 268 percent of gross domestic product, the outlook is for a very long period of subdued growth and one in which there is no assurance that the tools of economic management, traditional or not, will be effective.

The Federal Reserve released its Flow of Funds report last week, detailing the state of the country’s various balance sheets and the news was good, in its own way, but not encouraging.

Keynesian stimulus works perfectly, but only if you can find politicians who don’t care about re-election and central bankers who aren’t interested in being liked.

The Obama administration, confronted with staggeringly high unemployment and a struggling economy, has proposed another round of, well, stimulus, this time in the form of tax cuts and investment incentives, but such is the toxicity of the word in current debate they can barely bring themselves to utter the “S” word.

As envisioned by economist John Maynard Keynes, in order to successfully run an economy based on counter-cyclical spending during downturns, you need to also have a policy of counter-cyclical savings during fat times. Budget surpluses must be built up so that they can be run down during recessions