Crisis lessons learnt bring global recovery

The evidence is building that the world economy is headed for a substantial recovery from the worst financial crisis since the Great Depression.

While pessimists see either another downturn or rapid inflation ahead, I believe neither will occur. The Federal Reserve has taken the proper measures to promote a stable economic recovery. To paraphrase Santayana: Those who ignore history are doomed to repeat past mistakes, but those who learn from history can act to avoid them.

The financial crisis was all-encompassing and affected every market worldwide. Stocks and hard assets collapsed and virtually every country's equity market sank by 50 per cent or more. As conditions worsened, even non-dollar assets fell although the economic crisis was "Made in the USA".

The dollar rose against all major currencies as investors rushed to US Treasury bonds, the best performing asset from late 2007 until March 2009. Even gold, which recently has been hitting new highs, sank in the early stages of the crisis.

Only the Japanese yen rallied relative to the dollar, as those investors who sold yen to fund riskier, higher yielding investments (called the carry trade) bought yen to unwind their positions.

We learned that when the chips are down, the world still loves the dollar and the markets expect the US to follow the right economic policies.

Policy response

The crisis has eased because of the central banks' policies. Virtually all central banks took their cue from history, and particularly from the events of the Great Depression. It was Milton Friedman who emphasised the Federal Reserve was designed to prevent a financial panic by lending reserves to banks. The central bank failed to do so in the 1930s and banks subsequently collapsed, along with the world economy.

Friedman won the Nobel Prize in economics for documenting and interpreting the causes of the Great Depression. Ben Bernanke made that history the core of his graduate studies in economics. Although he never expected to preside over a similar economic crisis, Bernanke vowed that he would not make the same mistakes. And, in contrast to the 1930s, he flooded the system with liquidity to ensure that the safe assets that consumers held – their banks balances, money market accounts, and other forms of saving – would be preserved.

The Fed's policies are working. As 2010 dawns, stocks have recovered most of their losses and are down less than 30 per cent from their all-time high reached some 27 months ago. In contrast, 27 months after the bull market high of September 1929, the stock market had lost 75 per cent of its value and was heading down more.

Avoiding deflation

A similar story holds for consumer prices. Two years after the stock market peak in 1929, the consumer price index had already declined by 13 per cent and was going to fall almost 20 per cent more before the Depression finally ended. Right now, the price level is about three per cent higher than two years ago, and there are few signs of deflation. Because of this, prices of goods and services have not plunged the way they did in the 1930s, and we have prevented the severe deflation that greatly exacerbated the Great Depression.

Despite the victory against deflation, pessimists claim the surge in Federal Reserve credit and government debt will cause economic misery by sparking the opposite problem: rapid inflation.

Raising rates

I don't think so. I believe the Fed has a plan to withdraw liquidity when the economy recovers and lending increases. This will require that the Fed raise interest rates, probably sooner than the market now anticipates. But just as Bernanke understands that the central bank can prevent a depression, he understands that the central bank is also the principal source of inflation and will act to prevent it. Barack Obama's administration may not like it, but the Fed will raise interest rates, nudging the fiscal authorities to get their house in order and reduce the deficit.


The writer is a professor of finance at The Wharton School and author of Stocks for the Long Run. The opinions expressed are his own

 

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