Moralists unwound

So the New York Fed has "clarified" that it will accept ABCP with a credit wrapper from the borrowing member bank. This seems another reasoned step in a progression of maneuvers aimed at targeting the informational aspect of the sub-prime contagion. However, as addressed in this piece from VoxEu calling for just such a step prior to the move, it does open the door just a bit to that moral hazard issue very much on the mind of m* and perhaps readers too.

Why is that? What is this moral factor attached to our views on management of the economy?

It is not just m* or the narrow group of curmudgeons and crackpots that make up a small but consistently entertaining portion of the intellectual stew each week raising the moral stakes. Arguments for "tough love" on Fed policy and the economy seem to be appearing more frequently than in past financial rough patches. This week even The Economist, (admittedly advocates of the moralist view on US and UK home prices - less so on weapons of mass destruction and wars of choice), asks "Does America Need a Recession?"

Others go even further. A recent piece from Bernard Connolly that caught m*'s attention mentions with incredulity that "the Fed is wedded to the view that "normalization" without "liquidation" is possible." Liquidation is a very strong word for capital destruction on a large scale. As retribution for the excess of the explosive growth in credit over the last twenty five years, the correctness of a major recession, if not liquidation and depression, is an article of faith for holders of this view, many of them sympathetic to economic and political philosophies often collectively referred as the Austrian School.

Why is it that the financial landscape of this period and the Central Bank policies most associated with them (see Subprime crisis: Greenspan's Legacy for one exposition, or James Grant writing in the NYT for another - or, if those are too mild for you, this is as good a departure point as any), whether malicious, inept, or simply an error of "optimism about productivity," come in for such strong reprobation from this crowd?

Mark Thoma, an academic economist whose Economist's View is a frequent source, confronts what m* has taken to calling "the moralists" view in a straightforward piece that also asks "Do We Need a Recession?"

...Recessions, popped bubbles and the like do not have to be somebody's fault and, as such, we don't necessarily have to extract blood from anyone to avoid it happening again. Perfectly reasonable actions a priori - in the sense of responding to the economic incentives that are in place - can still lead to bad ex-post outcomes. The people acting in the economic environment didn't write the rules, they're simply maximizing given the rules that are in place, so why punish them?...

He refutes the Economist piece on three points: that the "creative destruction" at the heart of a dynamic economy is not dependent on recession, that over-investment in housing will be absorbed in time and so is a bringing forward of supply rather than wasted consumption, and lastly that arguing that the Fed should not attempt to stabilize because it would only encourage more speculation and greater moral hazard reflects a set of priorities that obviates the need for a Fed in the first place, (if m* got that part right).

Thoma also cites Paul Krugman (link from pkarchive.org) on "the hangover theory" which he calls "disastrously wrong headed."

"...Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality--with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression--with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply....

"... nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present."

This is a thread m* will be returning to.