I’m reproducing the bulk of a very good (and possibly final) post by London Banker, a former central banker and securities regulator, that takes issue with some of the conventional wisdom surrounding the efforts to remedy our economic crisis via liberal applications of monetary easing and fiscal stimulus.

I happen in general to be sympathetic to minority views (conventional wisdom is generally wrong). And in this case, as I discuss below, I am worried that conventional wisdom rests on a thin and dubious set of data and assumptions.

London Banker’s arguments are two-fold: first, deflation is more likely than inflation because the underlying messes have not been cleaned up. Therefore investors will be leery of putting funds into risky investments. Note this differs from the commonly-held view that deflation can be cured without addressing institutional arrangements. Second, he argues that punitively low yields will lead foreign investors eventually to retreat even from government debt. He argues that they will tire at throwing good money after bad, and will prefer to seek returns closer to home.

This claim is hard to prove (one can argue that the high risk spreads are due to deleveraging, not distrust) but it is a serious issue if true. One of the things that worked for years in favor of the US is that it had the most liquid, deepest capital markets, That was due not just to the size of its economy, but also the fact that it had high standards for financial disclosure and generally strong investor protection. If investors come to doubt the fairness of the markets, or think that the rot in its economy is not being cleared out and will undermine growth, that will hold investment back. As Brad Setser has pointed out, foreign capital flows have consisted almost entirely of central bank purchases of Treasuries and Agencies for quite some time, hardly a vote of confidence.

We also have the question of how long the high dollar/low Treasury interest game can go on. Bernanke wants rates low to try to stimulate economic activity and has even broached the idea of long bond purchases to keep yields on the long end of the curve down. But the poster child of deflation and low interest rates is Japan, which due to its high savings rate, was not dependent on external funding. The US should want the dollar cheaper to boost exports, but that risks the ire of our creditors, who would take big losses on their FX reserves (many economists argue this idea is specious, but try explaining the loss in paper wealth to a populace not schooled in such niceties. FX losses, when the dollar was weakening earlier in the year, produced a lot of ire in China, including among bureaucrats). Similarly, even if you subscribe to the deflation outlook, 3%ish 30 year bonds is a pretty risky bet independent of the currency risk. So it looks like our friendly funding sources are likely to get burned one way or another, perhaps both. There is a real risk of a disorderly fall of the dollar, and it is hard to tell what the collateral damage would be.

Now to my doubts about the proposed remedies, namely monster stimulus and monetary easing. First, as mentioned before, the analogy is to the US in the Depression, which we have said repeatedly before is questionable. The US in the 1920s was the world’s biggest creditor, exporter, and manufacturer. Our position then is analogous to China’s now. Indeed, Keynes in the 1930s urged America to take even more aggressive measures, and argued that it was not reasonable for the US to expect over-consuming, debt-burdened countries like the UK and France to take up the demand slack. So even though most economists are invoking Keynes, it isn’t clear he’s prescribe such aggressive stimulus for the US and UK now.

Second, the argument is that the US in the 1930s and Japan in its post bubble era failed to engage in sufficiently large stimulus. That is mere conjecture; there is no way to prove that argument (we cannot go back in a time machine and test different remedies in both economies).

In the US, the claim generally made is that the US did not emerge conclusively from the Depression until it engaged in massive wartime spending starting in 1939-40, and therefore a stimulus of perhaps that large a magnitude is required. However, quite a lot happened between 1930 and 1939, including going off the gold standard, the securities law reforms of 1933 and 1934, the creation of the FDIC, refinancing homeowner debt to longer-term mortgages via the Homeowner’s Loan Corporation, and the closure of a lot of business, some of which were probably victims of circumstance, but others probably deserved to be put out of their misery.

There is another huge extenuating circumstance with the war spending that observers choose to forget. The US’s problem in 1929, like China’s appeared to be (at least in part) overproduction, that there might be too much global capacity relative to consumer demand (that is certainly true for the auto industry now, which had managed to forestall the day of reckoning by converting consumers to leases that had them trading in cars after 3 years, when buyers generally keep them longer, Decreasing the effective life of cars was tantamount to increasing demand). In addition, the US suffered a fall in GDP of 11% in 1946 and 1% in 1947 in transitioning off a wartime economy.

But perhaps more important, at the end of WWII, productive capacity in the next two biggest industrialized nations, Germany and Japan, had been destroyed. The US had effectively no competition for its bulked up industrial capacity.

Had the US in 1930 tried monster stimulus, without the painful adjustments of the 1930s, would it have worked? Probably narrowly, in keeping unemployment from rising to horrific levels and containing the fall in GDP. But I question whether it would have been a panacea. The New Deal, contrary to popular opinion, did produce a lot of good results with its workfare, such as the building of parks and roads, the electrification of rural America. if the US had attempted something at twice that scale, would it have been productive? Some argue that it didn’t matter, the important thing is to get money into the economy, but I wonder. Japan did engage in pretty heavy infrastructure spending (a lot of bridges to nowhere) and it does not seem to have done them much good.

Note my sophisticated investor buddies disagree, saying this is backwards looking, confident that a US budget deficit of 10% of GDP next year will do the trick, and think inflation/hyperinflation is the bigger risk (note some consider hyperinflation to be operative at 20% per annum; you do not need to get to Weimar scenarios for inflation to start distorting economic decisions in a very serious way).

From London Banker:

For a while now I have been on the fence on the inflation/deflation issue …. I’m now coming down on the side of deflation for a very simple reason: there is no longer any incentive to save or invest, and so debt and investment cannot increase much beyond current bloated levels. In Lombard Street, Bagehot’s seminal tome on fractional reserve central banking, Bagehot advises any central bank facing a simultaneous credit crisis and currency crisis to raise interest rates. By raising rates they will ensure that foreign creditors remain incentivised to maintain the general level of credit available while the central bank resolves the local liquidity crisis through liquidation of failed banks and temporary liquidity support of stressed banks.

Yves here. For the UK, the currency crisis issue is a real concern. Recall that the pound has taken a huge dive in recent months, and Willem Buiter has taken to comparing Britain to Iceland. Back to the post: