Visiting Scholar Lawrence B. Lindsey

In the past week the same questions have kept coming up. Is this 1929? Are we headed for a depression?

Given my reputation, The Sunday Times asked me to be as cheery as possible. So to begin, readers should bear in mind that, even if we are headed for a depression, it will not be like the memories or pictures from history books we have of the 1930s.

In 1929 Americans had the per capita GDP of people now living in the Balkans. Today it is five times higher. So even if we have a depression, there won’t be any “Hoovervilles” or soup lines. There will be much higher demand for public assistance and rental housing. This is hardship, but it is not the privation of the 1930s.

Even the smartest people make mistakes. Sir Isaac Newton lost money in the South Sea Bubble. He not only figured out gravity, but was Master of the Mint, as close to being a central-bank governor as one could be back then. Recognising the developing bubble, he sold his position. Then, when prices continued to rise, he felt that he might have been mistaken and bought back in just before the top, losing a small fortune.

With roughly three and a half centuries of experience with financial bubbles that burst, we can make some reasonable judgments on how this one will end and what the world will look like afterwards.

First, there will be a significant redistribution of wealth, largely through its destruction for significant portions of the population that are presently fairly well-to-do. The wealth loss will appear rather random and therefore unjust, coming down to things like which bank you happened to have your deposit in, which company you worked for, or which investment house managed your pension fund.

But by far the most inevitable economic development will be an expansion of the balance sheets of the government and its central bank.

When credit bubbles burst an enormous hole is formed in private-sector balance sheets. Debtors are forced to sell assets at distress prices to pay creditors, often at only a few pence in the pound. Those creditors are usually also debtors to others, and they too must liquidate assets. Asset prices continue to drop until a bidder emerges. That bidder must have both courage to bid while prices are still falling and a very deep pocket. Government, and only government, inevitably fits the bill as it can both tax and print the resources it needs.

The US Treasury secretary Hank Paulson has had the legal authority to buy virtually unlimited amounts of both the debt and equity products of our giant mortgage securitisers, Fannie Mae and Freddie Mac since July. This week that authority is likely to be extended to private-label mortgages and derivatives. This should drive down the cost of mortgages for potential homebuyers, creating more of them, and at some point placing a floor under home prices. As home prices stabilise, asset values in the financial sector will bottom out and a slow recovery will begin. The volume will be increased until it looks like the strategy is succeeding.

Moreover, the recovery will happen all the more quickly if Paulson finances his purchase of mortgage securities by selling long-dated Treasury bonds to the central bank. When the central bank buys the Treasury’s bonds, it creates money. This expansion of the money supply not only helps to keep down borrowing costs relative to selling the bonds to private bidders, it also creates the spectre of inflation, or at least an antidote to incipient deflation. This also helps stabilise asset prices, improve collateral values, and thereby improve financial balance sheets In this regard, America is particularly blessed by a political economy and a central bank mandate that is biased to that outcome.

By contrast, the Bank of England, and particularly the European Central Bank, have mandates that require them to fight inflation first and foremost. This necessarily delays their adoption of a deliberately reflationary monetary policy.

This leads me to a conclusion that is downright cheery. Because of our political economy, America will adopt a reflationary policy consistent with what is outlined above very soon, possibly before the end of this year. The next few years will still not be easy ones, but the kind of disaster that people worry about when they think of the Depression is highly unlikely.

However, there is no free lunch, and the price is most likely to be a loss of faith in the transparency and consistency of American capital markets as the rules are changed so quickly, a decline in the attractiveness of the dollar as a reserve currency due to the reflation, and, ironically, less freedom to reflate in the future for our central bank.

Lawrence B. Lindsey is a visiting scholar at AEI.