Stock markets have had a terrible week. The Footsie had its worst performance since 2002, Asian markets their worst in 27 months and the Dow hemorrhaged.

Markets had rallied since mid-July on the back of falling oil prices, but perceptions have changed: the dominating thought now is that the weakness of the global economy has caused commodities to fall.

A global economic slowdown looks very real as profits fall, house values collapse, food and energy costs hurt consumer's discretionary dollar, and unemployment is rising.

Market leaders are demanding monetary and fiscal stimulus. A typical example is the very influential Jim Cramer who yelled "we need another rate cut" on his September 5 Mad Money TV show. He said deflation was the worst he had seen, with commodity prices plummeting and houses losing value by the minute. Moreover, Fannie Mae and Freddie Mac had to be bailed out "to save our homes".

Paradox
This raises a paradox: this writer has always said we got into the pickle we are in because lending was too lax, risk was ignored and liquidity too high. A series of bubbles were created and they have to be deflated and deleveraged. It is difficult to agree with the idea that more of the same medicine will assist.

To add a paradox to a paradox, the North Atlantic policy makers pride themselves on their realism. They believe they can be tough and can deal expeditiously with dead wood. Europeans and the British take pride in the autonomy of their central banks. It is the jewel in the crown of their policy. The Fed also claims autonomy and a degree of omniscience.

Some evidence for this is the Economist's Economic Focus "lessons from a lost decade" (August 23) which asks the question "Will America follow Japan into a decade of stagnation?" The article claims that Japan was remiss in failing to clean up its banking system. Moreover, the US is activist: its regulatory system, financial markets and political structure will not allow it to procrastinate. The US will force business to repair its balance sheets.

This toughness is not apparent to all observers. Indeed, the US failed to clean up after the tech-wreck in 2000. Instead Greenspan created many of today's problems by setting loose a flood of money.

Wlllem Buiter
Policy makers are goaded by Willem Buiter of the London School of Economics. Buiter's blog on the Financial Times has an interesting article on the new reality of diminished expectations. He says the global growth prospects are worse than expected, but an economic bust is necessary.

Busts play an essential role: they clean up the mess created in the boom by inflated expectations, over-optimistic plans and unrealistic ventures. These become embodied in household debt, productive capacity of no foreseeable use, excessive corporate and financial sector leverage, and enterprises whose only asset is hope.

Financial stability was undermined by thoughtless liberalisation, especially in the US and UK. Soft-touch regulation permitted an explosion of opaque instruments often held by non-transparent institutions. The UK lacked a functioning deposit insurance scheme, and no special regime for insolvent banks. In the US no one was in charge, and few were aware of the dysfunctional developments taking place.

The result is the over-expansion of banks, housing bubbles and excessively indebted households. It will take two-three years to work off the excesses.

Buiter's blog did not discuss policy options, but the inference is a hawkish regime is needed to see the correction through.

Buiter's remedies
Buiter was ignored by policy-makers until they met at Jackson Hole, WY. He fired a 150 page salvo , "The North Atlantic Financial Crisis", criticising the central banks, especially the Fed, which he alleges, suffers from "cognitive regulatory capture" by Wall Street. As Bloomberg reported, "Former Bank of England policy maker Willem Buiter sparked the biggest debate  by saying "the Fed listens to Wall St and believes what it hears". "This distortion"¦is unhealthy and dangerous."

Buiter also says the Fed over-reacted to the economic slowdown, misjudging the importance of financial stability to the economy, and thereby creating a massive inflation problem. Letting house prices fall is not the end of the earth, and the correction needs to runs its course.

Buiter says the Fed has less independence than the ECB or the BoE, and fears political encroachment on its role, so it overreacts to signs of economic weakness. The central banks are too inclined to blame inflation on external shocks, specifically food, fuel, and commodity prices. The Fed also uses the funds target interest rate to address financial stability problems. The central banks allowed asset bubbles to run too long.

Reactions
Buiter was roundly attacked. Outrage was expressed by Fed Governor Frederic Mishkin, who had earlier undertaken research with Bernanke. Mishkin denied that rate reduction led to inflation of consumer goods. Mishkin gives priority of economic growth and thinks the Fed should act "more aggressively". Buiter said Mishkin's strategy had no obvious value.

Former Fed Vice-President, Alan Blinder, replied for the Fed against Buiter's "outrageous statements". He thought the Fed's performance was "pretty good"  - like the Dutch boy had prevented a dam burst and deluge. Buiter would have allowed the dam to burst out of his belief in moral hazard.

Some analysis
Some have suggested that Buiter's English-academic style offends because is too brusque for American taste. Moreover, Fed officials are outraged by the idea that they have succumbed to deliberate orchestrated  pleading by smooth Wall Street executives.

It is possible that, even if the Fed is too close to Wall Street, it might still have made the right decisions. This column judged that Bernanke behaved appropriately in brisk action to save Wall Street from financial meltdown. Nevertheless, it must be admitted that when a big financial institution is about to fail, Wall Street starts screaming "fire", or "dominoes" or "systemic failure".

Perhaps is too soon to say how effective the Fed's interventions have been because most expert commentators, like the Economist, believe the worst is still to come.

http://www.nber.org/~wbuiter/hole.pdf 
http://blogs.ft.com/maverecon/

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*Neville Bennett is a long-time Senior Lecturer in History at the University of Canterbury, where he has taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared.