Last week Mohamed El-Erian gave a speech at the St. Louis Fed explaining why continued extraordinary actions by the central banks risk creating more problems than they solve. He does a good job of detailing why central bank actions can only buy time for policy makers to take the actions that will solve the crisis – and the dangers of continuously buying time, when policy makers decline to recognize the nature and seriousness of the problems they face. I find some of his rhetoric dangerous however.
El-Erian repeats the mantra that “central banks succeeded in their overwhelming priority of avoiding economic depression.” But this is precisely what they have not done, because a central bank’s toolkit does not enable it to address structural problems with the balance of trade. Those must be addressed by policy makers – and thus policy makers are the only ones with the tools to avoid forced, sudden adjustments in such imbalances and economic depression. Central banks can buy policy makers the time in which to act – but they can do no more than that.
By analogy with the Great Depression, we are currently somewhere in the late ’20s. In 1925, after the Dawes plan had stabilized the European balance of payments situation via American lending to Germany, the central bankers got together and decided to work together to help Britain return to its pre-World War I peg to gold – expecting or hoping that policy makers would cooperate in this endeavor and facilitate the global rebalancing that needed to take place. Instead French policy decisions, for example, ensured a steady inflow of gold, and capital flows were overall driven by disequilibrium exchange rates until in 1931 the system broke: Britain finally acknowledged that the peg to gold could not be maintained and the international economy tumbled into Depression (though the move helped Britain put an end to a decade of stagnation).
Thus 2008 looks very like 1925. Our efforts to muddle through may have been more effective than in the late twenties, because many understand that the underlying problem of trade and capital flow imbalances must be addressed. On the other hand, policy makers’ actions have definitely been insufficient to date and there is good reason to fear that the vast challenge of international policy coordination will prove too great and that our system too will break under the stress of ongoing imbalances sometime over the next decade.
This concern was clearly expressed by El-Erian. But he chose not to call it by its name. What El-Erian is worried about is a second Great Depression. And, as he states clearly, the only people with the tools to stave off such a crisis are the policy makers. The question is whether they will fail as their 20th century forebears did before them.