The severity of the credit crunch has taken the world's central bankers by surprise. But they might have foreseen it had they not been intellectually enslaved by the ideas of the recently-deceased über-economist, Milton Friedmanby Edward Chancellor / December 20, 2008 / Leave a comment
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It is a grave error to ascribe the credit crisis to greed. Financiers will always cut corners to make a quick buck. Investment and commercial bankers, hedge fund managers, the staff of ratings agencies and just about anyone else employed in the financial world may be worthy targets of our criticism. But their behaviour was predictable. The real responsibility lies higher up. Central bankers are the appointed guardians of the credit system. Yet not only did they fail to predict this crisis, their mistaken policies are directly to blame for the mess we’re in.
The greatest error of central bankers has been their failure to understand the dangers posed by asset price bubbles. Former Chairman of the Federal Reserve Alan Greenspan led the central banking community in claiming that it was impossible to identify bubbles in advance. In fact, it’s pretty easy to spot a bubble forming—many analysts, including Robert Shiller of Yale University and Andrew Smithers of Smithers & Company, correctly identified both the technology and real estate bubbles of the last decade in advance. Only the current Fed chairman Ben Bernanke and a few excitable property speculators or “flippers” were caught off guard when the property bubble burst.
Furthermore, our financial guardian angels gravely underestimated the damage inflicted by the collapse in real estate values. Yet it should have come as no surprise that the solvency of the banking system could be threatened by such an event. That’s what happened in Japan in the 1990s. Nor was it a secret that real estate crashes inflict great damage on the economy. Both the Japanese and the Scandinavian property crises of the early 1990s were followed by severe economic downturns.
Instead of addressing the real estate bubble, central bankers in Britain and the US rationalised it, contending smugly that improved monetary policymaking justified people taking on more debt and paying more for their homes. They were also convinced that they had the correct tools to deal with a deflating bubble. As technology stocks spiralled in the late 1990s, former Fed vice-chairman Alan Blinder looked sanguinely on the prospect of a stock market collapse. “For the US economy to go into a significant recession, never mind a depression,” said the Princeton economist, “important policy makers would have to take leave…