The Fed Failed Basic Economic Thought ~ Steve Blitz Morning Notes
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Tuesday, April 28, 2009

The Fed Failed Basic Economic Thought

Today's FT has an article by Henry Kaufman on "How Libertarian Dogma Led the Fed Astray" He writes:

"..... Its failure to spot the importance of changing financial markets and its commitment to laisser faire economics were big mistakes and justify a fundamental overhaul of the Fed.

The first of these shortcomings was its failure to recognize the significance for monetary policy of structural changes in the markets, changes that surfaced early in the postwar era. The Fed failed to grasp early on the significance of financial innovations that eased the creation of new credit. Perhaps the most far-reaching of these was the securitisation of hard-to-trade assets. This created the illusion that credit risk could be reduced if instruments became marketable."
Last October, Kenneth Arrow wrote in the Manchester Guardian:

"There have been two developments in the economic theory of uncertainty in the last 60 years, which have had opposite implications for the radical changes in the financial system. One has made explicit and understandable a long tradition that spreading risks among many bearers improves the functioning of the economy. The second is that there are large differences of information among market participants and that these differences are not well handled by market forces. The first point of view tends to argue for the expansion of markets, the second for recognising that they may fail to exist and, if they do come into being, may fail to work for the benefit of the general economic situation."
I would like to add this definition of the Theory of the Second Best from Wikipedia:

"The Theory of the Second Best concerns what happens when one or more optimality conditions are not satisfied in an economic model. Canadian economist Richard Lipsey and Australian-American economist Kelvin Lancaster showed in a 1956 paper that if one optimality condition in an economic model is not satisfied, it is possible that the next-best solution involved changing other variables away from the ones that are usually assumed to be optimal.

This means that in an economy with some unavoidable market failure in one sector, there can actually be a decrease in efficiency due to a move toward greater market perfection in another sector. In theory, at least, it may be better to let two market imperfections cancel each other out rather than making an effort to fix either one. Thus, it may be optimal for the government to intervene in a way that is contrary to laissez faire policy. This suggests that economists need to study the details of the situation before jumping to the theory-based conclusion that an improvement in market perfection in one area implies a global improvement in efficiency."

The Fed's role in creating the current mess is writ large. Greenspan, Bernanke, Poole, Mishkin, Yellen, et al all fell victim to an ideological group think that monetary policy should be run as if we live in a market economy with perfect information. We don't and at the same time, borrowing a bit more from Arrow's work, the Fed's central bank counterparts aren't voting for the same pareto optimal solution. For the Fed to manage policy and its regulatory stance as if all this were true is astounding considering all those high SAT scores sitting on the FOMC. And these are the same leading lights engineering the recovery? Considering how Bernanke et al are still pinning all the blame on the banks I have to agree with Henry, some major changes are in order.

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