Why the pump priming won't help the financial crisis

All round the world a model has been developed where monetary policy has been put into the hands of technocrats not elected by the people, nor accountable to the people.

Fiscal policy has been left with the elected politicians but, effectively, all this has achieved is leaving fiscal policy in neutral in a macroeconomic sense because the political elites have perfected the culture of not being responsible for economic outcomes. Thus monetary policy has been the only vehicle available for economic policy makers.

Thus when speculative bubbles have emerged central banks have been faced with two alternative responses: first, do nothing until the bubble bursts and then utilise loose monetary policy or, second, take pre-emptive action by raising interests rates and bludgeon the rest of the economy.

The problem is exacerbated when the speculative bubble occurs in the nation whose currency is effectively the world’s reserve currency. The second course of action effectively induces a world-wide recession.

If there was no separation of fiscal and monetary policy then the decision makers could have all the economic tools available to them.

For instance, when the dot.com boom turned into a property boom, governments could have reigned in the bubble by increasing property taxes or mortgage taxes or altered capital gains taxes. Alternatively they could have regulated mortgage securities to ensure that prudential practices occurred such as implementing the Danish system where mortgage originators issue redeemable bonds to the value of the loan and not allow cross contamination between institutions.

The Danish system ensures that the risk remains with the lenders and is not transferred to the holders of the mortgage securities and thus guarantees prudential lending. If the bond decreases in value the property owner has the option of simply purchasing the bond and using the bond to redeem the loan on the property. So the individual lending institutions have to pay the piper if they write dodgy loans.

This would have stopped the insane speculation caused by loose monetary policy and would not force central banks to bludgeon the rest of the economy. It also means that the political elites have to accept responsibility and cannot hide behind the faceless technocrats in the central banks.

So why then is a new Bretton Woods Agreement necessary? Why not simply put the elected representatives back in charge of both monetary and fiscal policy?

While restoring economic democracy is vital, that in itself will not fix the problem.

The United States has been living beyond its means; its current account deficit is unsustainable. It simply will not have the economic capacity to ever repay its foreign debt. What will happen once this fact is realised?

The creditor nations will have a firesale of US assets (currency and bonds) to try and minimise their losses before the bonds acquire junk status, thus triggering the biggest deflation event in the world’s history and along with it the greatest depression in the world’s history.