Ever wonder why we had two recessions in less than 10 years or how the current recession is going to end?
To discuss the causes of the financial crises, potential recovery scenarios and Austrian economics, The News-Letter sat down with Professor Steve Hanke, who serves as co-director of the Hopkins Institute for Applied Economics as well as the Study of Business Enterprise.
Hanke is also a Senior Fellow at the Cato Institute in Washington D.C., a columnist for Forbes magazine and a renowned currency and commodity trader.
Here he presents his thoughts on the current financial crisis, the possible path the recovery will take and economic models.
Cause of the Financial Crisis
One common explanation for the financial crisis involves the real estate "bubble". The Federal Reserve (Fed) kept interest rates too low for too long, banks like Fannie Mae and Freddie Mac pushed sub-prime mortgages on unsuspecting consumers, Wall Street packaged mortgage debts into derivatives and financial models predicted real estate prices would increase indefinitely.
What Hanke feels was not addressed appropriately is the Fed's inflation targeting policy. In November 2002, then-Fed governor Ben Bernake gave a talk about his fear that the U.S. economy would soon experience deflation.
"Bernake convinced Greenspan that deflation was eminent and a significant threat. It later turned out that Bernake was thrown off-base by a statistical error in the price index," Hanke said.
As a result, the Fed cut interest rates to an unprecedented low of 1 percent in July 2003.
This caused a credit boom and commodity bubble, which became particularly apparent during the summer of 2008 when gas prices were as high as $4 a gallon. Food prices skyrocketed as well, which especially hurt third world economies.
According to Hanke, commodity bubbles are created primarily by loose money and the dollar's depreciation.
"Around 55 to 65 percent of commodity price increases were attributable to a decrease in the value of the dollar," he said.
As early as 2007 the economy was slowing down, but the Fed was equally slow to take action, and as a result the recession hit.
Why was Bernake concerned about deflation to begin with? Deflation occurs when the same amount of money will buy more goods or services. An example is the falling price of laptops from productivity efficiencies; your laptop today can do more than the laptop you had five years ago, and is probably cheaper as well.
It would seem deflation is favorable compared to the alternative: inflation. Inflation reduces the purchasing power of currency.
Unfortunately, during the Great Depression the U.S. experienced a bout of "bad" deflation when the Fed dramatically reduced the currency supply.
What is more unfortunate is that Bernanke was a student of the Great Depression (a fact he likes to remind the populace of every so often).
His fear of deflation coupled with his incorrect evaluation of the U.S. economy back in 2002, led the Fed to slash interest rates and fuel the ensuing asset bubbles.
A "W Recovery"
"Normally, the shape of a recovery following a financial panic is a 'V', because there is an enormous capacity for the market to rejuvenate," Hanke said.
He explained that we did not experience a 'V' recovery primarily because of a phenomenon known as regime uncertainty.
Regime uncertainty results when people become concerned with the stability of private property rights because the government begins nationalizing businesses.
Hanke also points to the importance of government outlays. He notes that under the Clinton presidency and Republican Congress, government outlays were around 18.5 percent of GDP.
Bush left office with outlays around 23 percent. Obama's first year outlay is 26 percent. The Congressional Budget Office's optimistic forecast for government outlays in 2019 is 24 percent of GDP, based on the current budget.
"Outlays at 24 percent of GDP are outside the post-World War II range and this makes people very anxious," Hanke said.
Outlays foretell future taxes, because they are either financed by taxes or bonds. Taxes are paid now, whereas bond finance is equivalent to purchasing on an installment plan.
"We are witnessing a slower recovery than usual, because taxpayers know they will ultimately have to pay the bills and are worried," Hanke said.
He argued that the Fed is continuing its inflation-targeting monetary policy described above and does not care about the value of the dollar.
"A weak dollar causes higher commodity prices, which ultimately feed through to higher rates of inflation," Professor Hanke said.
His main point is that he expects the U.S. to see a slow recovery, a weak dollar, rising commodity prices and high unemployment rates. But the Fed will eventually have to start fighting inflation, which will trigger the second dip in the W.
Austrian Economics
Austrian economic principles predicted many of the asset bubbles in the last 100 years. Ludwig von Mises, one of the fathers of the Austrian school, anticipated the Great Depression in The Theory of Money and Credit (1912).
"Mises was offered a position in the Creditanstalt [a private bank in Vienna, Austria], but he refused it because he anticipated a crash and did not want to be associated with it." Hanke said.
Similarly, many current economists, including Hanke, had predicted the real estate bubble and ensuing crash well in advance of the financial crises last year.
Many Austrian principles, such as Ludwig Lachmann's idea that stock markets reflect future expectations, analysis of business cycles and Oskar Morgenstern's ideas about game theory, have been absorbed by mainstream economic thinking.
The Federal Reserve, however, is primarily of the neo-Keynesian bent.
"Opportunists find in Keynes' ideas a justification to ratchet up government outlays. Once the scope and scale of government become larger, it's hard to turn back the clock." Hanke said.
An example of this is the Agricultural Adjustment Act passed during the Great Depression to subsidize farming. Still in existence decades later, farm subsidies hit record levels last year, just as commodity prices also reached record levels.
Thoughts for Students
If a general student is interested in learning more about economics, Hanke recommends Henry Hazlitt's Economics in One Lesson as a good start. It uses economic analysis to demonstrate how economists think about a variety of problems and is an easy, readily understandable read for an amateur.Hanke also recommends that students heed the five P's: Prior preparation prevents poor performance.
"Students must keep their eye on the ball and prepare for what will hit them in the real world," Hanke advised.
