A painful cleansing or pain avoidance at all cost?

March 25th, 2007

Share |

Back in Inflation or deflation first?, we mentioned that,

Now, faced with the threat of a deflationary recession, what can the Fed do? Politically, it is impossible for them to allow a recession run its full course in order to clean up the prior excesses of the bubble. They will do anything and everything to ?prevent? another recession. The only way for them to do that is to do what they always did?pump even more liquidity into the economy (a.k.a ?print? money).

We believe that the US is likely to face a severe recession. When that happens, we will see an accompanying great fall in financial asset prices. That is, asset price bubbles will collapse. What is the Fed to do in that case?

Economists from the Austrian School of economic thought will recommend a painful cleansing of the economy through a recession. Through the liquidation of mal-investments during the bust, it will set the scene for a sounder and more sustainable economic growth in the long run.

But will the Fed follow the Austrian recommendation?

We believe it is highly unlikely. Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible. As we can see in this article in Bloomberg, Senate Weighs Aid to 2.2 Million Subprime Borrowers (Update4), the Fed will have to submit to the mob eventually.

This will set the stage for monetary breakdown and the loss of confidence in fiat money.