Re: To prevent bubbles, restrain the Fed

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(email exchange)

Right, add CATO to the list of organizations that have no credibility and now put the Dallas Fed on the suspect list as well. The difference between now and 1929 is back then we were on the gold standard he proposes, and therefore didn’t have the option for the Treasury to deficit spend without the loss of the nation’s gold reserves and devaluation/default as we ran out of gold. This also subjected the banks to true systemic failure as customers demanding their funds were entitled to convertible currency, which was limited by the same gold reserves. That’s exactly what happened as multitudes of banks failed, depositors lost their money, and the US both devalued for international purposes and was forced off gold domestically by 1934.

Since then, ‘automatic stabilizers’ (deficits counter cyclically ‘automatically’ rise in down turns and fall in expansions) and some proactive fiscal responses have resulted in much milder downturns and also have limited expansions.

The gold standard wasn’t abandoned because it worked so well- rather, because it has always gone down in flames:

To Prevent Bubbles, Restrain the Fed

By Gerald P. O’Driscoll

The incoming administration must think about that possibility because the timing of boom and bust cycles seems to be shortening. The next bust could come five or six years from now — or about in the middle of an Obama second term. Should that happen, Mr. Obama would be unable to blame Republicans for the mess and would be tagged as the second coming of Jimmy Carter.

To avoid such a fate, Mr. Obama needs to stop the next asset bubble from being inflated by imposing a commodity standard on the Fed. A commodity standard (such as a gold standard) imposes discipline on a central bank because it forces it to acquire commodity reserves in order to increase the money supply. Today the government can inflate asset bubbles without paying a cost for it because the currency isn’t linked to the price of a commodity.

With a commodity standard in place, the government would also have price signals that would alert it to the formation of a bubble. Why? Because the price of the commodity would be continuously traded in spot and futures markets. Excessive easing by the Fed would be signaled by rising prices for the commodity. In recent years, Fed officials have claimed that they cannot know when an asset bubble is developing. With a commodity standard in place, it would be clear to anyone watching spot markets whether a bubble is forming. What’s more, if Fed officials ignored price signals, outflows of commodity reserves would force them to act against the bubble.

The point is not to deflate asset bubbles, but to avoid them in the first place. Imposing a commodity standard is a practical response to the repeated failures of central banks to maintain sound money and financial stability. What would be impractical is to believe that the next time central banks will get it right on their own.

Mr. O’Driscoll, a senior fellow at the Cato Institute, was formerly a vice president at the Federal Reserve Bank of Dallas.

>   On Tue, Nov 18, 2008 at 10:27 PM, Ron wrote:
>   Warren,
>   I know you’ll love this one.