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The late Rudi Dornbusch, the renowned MIT economist, said of the Mexican Central Bank Board that he could understand it making mistakes. After all, its members were human. What he could not understand, however, was how the same people could make the same mistakes time and time again.
One wonders whether someone might not say something similar about the U.S. academic economist community in its repeated disregard of asset price inflation as an important determinant of how the U.S. and global economies are likely to perform.
In the run-up to the Great Economic Recession of 2008-09, almost the entire U.S. economic academic community underestimated the dangers of the housing and credit market bubbles. As a result, they were caught totally flat-footed when those bubbles burst. In late 1998, this prompted Queen Elizabeth II to famously ask why no one seemed to have warned her about the impending global asset price bust and about the serious global economic dislocation that would ensue.
Today, U.S. academic economists for the most part seem to be doing the same thing by virtually ignoring the tremendous increase in global asset market prices over the past few years. They are doing so even though today, those asset price bubbles seem to be more pervasive than they were before. While in 2008, those bubbles were largely confined to the U.S. housing and credit markets, today, they are all too evident in the global equity market, the global government bond and credit markets and selected housing markets in systemically important countries.
As an indication of how little U.S. academic economists seem to have learned from the earlier housing bubble and its subsequent bursting, all one needs to do is to look at the statements that prominent members of that community are now making about Janet Yellen’s legacy.
Paul Krugman, for one, keeps crowing that the massive bond buying by the Federal Reserve over the past few years did not create the price inflation that many conservative economists had feared. However, he makes absolutely no mention of the global asset price inflation caused by the expansion of the Fed’s balance sheet from $800 billion in 2008 to around $4.5 trillion at present. Needless to add, he is totally silent about the dangers that past asset price inflation might be posing now to the global economic outlook.
Similarly, at the very time that signs of incipient U.S. inflation are emerging and that fear is gripping financial markets that we might be in the midst of a global asset price bubble, Larry Summers is choosing to write op-eds claiming that Janet Yellen could not have left Jerome Powell with a better legacy.
Nobody seems to have told Summers that in 2017, Yellen’s Fed did not alter the Fed’s interest rate path. It failed to do so despite the strong boost that a close-to-full-employment U.S. economy was receiving from the combination of a 25 percent increase in U.S. equity prices, a 10-percent dollar depreciation and the large unfunded Trump tax cut. In all probability, this has left the Fed well behind the interest rate rising curve, which realization is now roiling the U.S. bond market.
More disturbingly yet, no one seems to have told Summers that by keeping monetary policy too low for too long, the Yellen Fed, along with the world’s other major central banks, have created a global financial market bubble of epic proportions. This bubble is to be seen in global equity valuations at lofty levels experienced only three times in the last 100 years, in government bond yields at historic lows, and in serious credit market mispricing.
All of this would be of little importance if academic economists had limited influence on economic policy-making decisions. However, as John Maynard Keynes famously observed, it is a mistake to underestimate the influence of academic economists since “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
For this reason, we have to hope that this time around, when the global asset price bubble bursts, the academic economic community will draw the right lessons about the dangers of ignoring asset price inflation in monetary policy formulation. Maybe then, we will have some hope of freeing ourselves from the global boom-bust economic cycles that we now seem to be experiencing at ten year intervals.
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