TCS Daily


Self-Imposed Crisis?

By Craig S. Marxsen - October 17, 2008 12:00 AM

Larry Kudlow (TCSDAILY, 06 October 2008) correctly emphasizes the monetary tightening that unwittingly set the stage for the current financial crisis. How can such an old-fashioned liquidity crisis panic financial markets under today's regime of fiat money? The Federal Reserve was fighting energy and food inflation by slowing the money growth rate. The low interest rates were an ambiguous indicator of monetary policy because an energy crisis was depressing the return on expansions of the capital stock. The energy crisis of the 1970s also depressed the real or inflation adjusted interest rate in a feedback loop that further discouraged petroleum extraction.

After growing at annualized monthly rates of about 17% and 12% in February and March of 2008, the growth of the M2 money supply slowed to 2.4%, 1.3%, -0.2%, 6.1%, and -1.5% in April, May, June, July, and August (seasonally adjusted). Indeed, the rate of growth of the money supply has slowed prior to every recession in the post World War II era, according to Frederic Mishkin (2007, p. 9), in the latest edition of his widely adopted Money and Banking textbook. The Federal Reserve tightened money growth (or failed to ease it) when the real estate market underlying the then and now collapsing mortgage derivatives market was already in a free fall.

At the bottom of this energy and food inflation was a political effort to fight global warming by discouraging investment in fossil fuel production capacity and encouraging the use of renewables such as ethanol made from corn. During the past year, major petroleum producing firms announced drastic cutbacks in energy infrastructure investment plans. Similar efforts were in progress in other countries. Rising gasoline and diesel fuel prices rippled through the economy, affecting everything that moves by fuel-powered vehicles. A massive diversion of farm capacity toward fuel ethanol production occurred while federal and state governments eliminated MTBE, a virtually harmless gasoline component synthesized from natural gas and constituting about 3% of the nation's gasoline supply. The inflation surge was reminiscent of the mid-1970s energy crisis that also produced an inflation that the Federal Reserve elected to fight with tight monetary policy.

The use of monetary policy to arrest a cost-push or supply-side inflation driven by an energy crisis distressed the American economy in the middle of the 1970s. Raburn Williams, in his The Politics of Boom and Bust in Twentieth-Century America (West Publishing Company, 1994, pp. 386-388), explains how the Federal Reserve tightened monetary policy in response to skyrocketing energy and food prices in 1974. This forced the other sectors of the economy, outside of food and energy, to experience sharp deflationary pressure as Arthur Burns used slow money growth to drive down inflation in them relative to the rising inflation in food and energy. The worst recession since the 1930s resulted then, and the stock market crashed, and President Nixon ended his presidency by resigning.

Unlike when the Great Depression of the 1930s began, the world is unconstrained in its ability to create money today. Governments will probably soon reverse the liquidity crisis underlying the collapsing financial markets by an infusion of money from central banks all over the world. However, asset appreciation that can save equities and financial corporations will also affect another asset -- the reserves of petroleum lying in the oil fields owned by today's major global producers. The value of that asset will probably again rise in tandem with another rise in fuels prices at the pumps. Low inflation adjusted interest rates seem a likely repercussion from resurgence of our present energy crisis, as stagflation mimics the late 1970s malaise once again.

A root cause of this situation begs for an obvious remedy if the public can muster the political will to call for it. An abrupt turn away from the policy of seizing every opportunity to obstruct and discourage the supplying of fossil fuels might moderate a late 1970s style resurgence of the recent energy crisis, and with it, the monetary roller coaster ride that is devastating the retirement dreams of the present generation of Americans and baby-boomers all over the world. An economically efficient response to the global warming problem would be far more modest than what we are unwittingly imposing right now.

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4 Comments

Maybe not the whole answer
but it certainly couldn't hurt. A very good article.

What response to 'global warming'?
What 'global warming' for that matter.

Anyone notice the peak occurred ten years ago and CO2 is not decreasing?

At a presentation by Richard Lindzen, MIT, about 'global warming', he said his wife follows the Algerian media, for some reason. The Algerian government budget planning next year prices oil between $30-40/bbl.

Free enterprise needs to be unleashed to reduce energy costs and determine the most efficient energy for every application.

But how much oil is undiscovered.
Current production in the hight producing contries is on the decline. These countries have no realy EPA holding them back, so I think we must get ready for the time of very expensive oil and for it to stay.

Build nuke power AND wind AND solar
Right now, in the beginning of a negative GDP growth recession (already in recession by many other accounts), it is past time for the federal gov't to support job creation with direct gov't investment.

Especially with house construction gone, the gov't should be building nuclear power plants. Also wind turbines on gov't land, and solar panel carports over the parking lots in hot, sunny, Southern cities.

Total Costs of ownership for each type of real-world construction should be published -- totally open accounting. This would also allow benchmarks in the future for different alternatives.

When tax increases are discussed, it is better to have a tax on gas than on income.

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