New Thinking on Dealing with Financial Crises

Poor Alan Greenspan. Only a short time ago the former head of the U.S. Federal Reserve was hailed as the guru of national economic management. Today, many blame him for the financial crisis that hit the American Economy and the world. What has changed?

The global financial crisis has brought with it a fundamental re-examination of many precepts which until recently were part of the accepted economic wisdom. The doctrine of efficient markets and the risk models based on this concept are no longer accepted as valid by many economists. Not even Adam Smith's invisible hand has escaped criticism. Though often guiding markets in the right direction, some experts now say that it may also point the economy toward the sort of bust we are now experiencing. The most basic change of all has to do with the focus on credit and particularly the overextension of credit as playing the key role in financial crises. Not that credit was held blameless during previous such downturns. Today however, there is a growing conviction that its role is more crucial than previously thought.

Economic thinking was quite different only a short time ago when Alan Greenspan was the darling of both government and Wall Street. To keep the economy growing while maintaining high levels of employment was generally considered to be the main task of a central bank. Through the aggressive reduction of interest rates, Greenspan encouraged consumers to continue borrowing and consuming. This ensured that the American economy continued growing, until it crashed.

TOO MUCH CREDIT

Today there is a growing perception that this thinking was misguided. Credit is both the lifeblood of an expansion as well as the root of its downfall.

A new book by George Cooper puts it succinctly:
"Credit creation is the foundation of the wealth generation process … it is also the cause of financial instability".*

An excess of credit and borrowing was certainly detectable in many of the countries which experienced the worst aspects to the financial crash. Spain, Ireland, USA, UK, Iceland, to name a few. Excessive credit expansion was evident in the dot-com boom of 2000, the crash of the Japanese economy, the recession associated with the American Savings and Loan Associations and of course, the famous 1929 crash. If too much credit and borrowing is to blame, it follows that encouraging excessive credit and borrowing plays a key role in bringing about such crises.

A NEW ROLE FOR CENTRAL BANKS

Following this line of thought a perception on the role of government and the central bank has emerged which is quite different from that pursued in the days of Alan Greenspan.

Using the interest rate and other tools to protect economic growth and employment against a downturn as long as possible should not be the main objective of the central bank. Since too much credit creation is at the root of the sort of the boom and busts the capitalist economies have been experiencing, it is up to governments and particularly central banks to monitor credit creation and to curtail it when it reaches danger levels.

“Financial management requires limiting credit expansion...” (G. Cooper)
How much credit is too much? Another aspect of the new thinking is the focus on asset prices rather than consumer prices. Rapidly rising share and house prices are key indicators, signaling excessive credit expansion.

This means that while credit fuelled prices in such assets are moving up and fortunes are being made, the central bank should step in, limit credit creation and dampen the expansion. This could be done through an increase of interest rates, just the opposite of what happened during the Greenspan years. The objective is not to bring about a financial crash but to avoid one through a timely slowing of credit.
"For all practical purposes this policy amounts to asking central banks to preemptively prick asset bubbles." (G. Cooper)

Or, in the words of the former Chairman of the American central bank, William McChesney Martin:
"The job of the Federal Reserve is to take away the punchbowl just when the party gets going."
The political and practical difficulties here are obvious. Unlike the more traditional approach (keeping the party going) the focus on limiting credit expansion will clearly face much popular and political opposition. Which government is prepared to curtail rising share prices and employment?

Our own politicians in Cyprus are not known for an aversion to parties and punch bowls. Would they be willing to raise interest rates to bring about a planned economic slowdown? It will be interesting to see what practical steps central banks may decide to take in support of this latest thinking.

* George Cooper, “The Origin of Financial Crises”, Harriman House, Ltd., 2008)

November 24, 2009 - Dr. Jim Leontiades, Cyprus International Institute of Management

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