Taylor, Getting off Track, Taylor rule, Bernanke monetary policy failure

Yet another failure of economic policy.

With unemployment still running over 8% and economic recovery still running at an anemic pace five years after the start of the Credit Crunch recession, the failure of the Keynesian economic policies adopted by the U.S. government and other governments around the world can no longer be doubted.
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The world staggers under the asserted stimulus of government deficits. Keynesian stimulus deficits in the U.S. in excess of a trillion dollars per year for four years have been to no avail. Both the Federal Reserve Bank and the European Central Bank (ECB) have monetized trillions of dollars worth of debts to no avail. Yet once again, as during the New Deal of the 1930s, and the Keynesian inflationary morass of the 1970s, massive experiments in Keynesian policies have failed. Yet once again, it is analysis of economic fundamentals, not simplistic Keynesian references to economic aggregates, that explains the problems. Once again, it is the liquidation of fundamental problems rather than Keynesian efforts to increase "liquidity" that permits economic recovery.
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The Taylor Rule:

The Credit Crunch was produced by government mismanagement.

The primary cause of the housing boom and financial bust of the Credit Crunch recession was Federal Reserve monetary policy. According to John B. Taylor, the Credit Crunch was produced by government mismanagement rather than by any inherent instability in the private economy. (Indeed, government policy has played a substantial role - and frequently the dominant role - in every economic contraction since WW-I. See, Our Government Directed Business Cycle.)
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A Keynesian response to the Credit Crunch that focused on liquidity instead of risk problems deepened and lengthened the subsequent bust.

In "Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis," Taylor emphasizes how departure from the successful rules-based monetary policy of the last two decades of the 20th century created financial conditions that encouraged the credit abuses of the housing boom, and how a Keynesian response to the Credit Crunch that focused on liquidity instead of risk problems deepened and lengthened the subsequent bust.

"[Taylor explains] how a series of unpredictable government actions and interventions with little or no basis in economic theory or experience threw the economy off track, increased uncertainty, and caused great economic harm."

The Taylor rule says that the interest rate should be one-and-a-half times the inflation rate plus one-half times the GDP gap plus one."

The "Taylor Rule" policy guide for monetary policy was developed by the author. The Taylor rule is a principled guide to monetary policy, not a mechanical prescription. It provides a rules-based monetary policy determined by actual price inflation and gross domestic product instead of by the electoral cycle and other political whims of the moment typical of current and 1970s Keynesian policy.
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"To be precise, the Taylor rule says that the interest rate should be one-and-a-half times the inflation rate plus one-half times the GDP gap plus one." The GDP gap measures how far GDP is from its normal trend level. The inflation rate used is a four quarter moving average.
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This guide fit well with the Fed's successful monetary policy during the 1980s and 1990s both before Taylor published it in 1992 and in the years thereafter. Although not designed as a forecasting tool, it has since been used successfully to forecast and analyze Fed policy. Alternative rules-based monetary policy guides include Milton Friedman's constant monetary-growth rate rule, and rules that focus on forecasts of inflation and real GDP or react to price level.

Fed policy following the dot com bust was initially driven by the political needs of the electoral cycle and by fear of a Japanese-type deflation, although there is no proof that the economic and financial fundamentals in Japan are similar to those in the United States. See, Porter, "Can Japan Compete?" Fed policy response and Bush (II) and Obama administration response to the Credit Crunch bust were driven by fear of a return to the Great Depression, although the financial and economic fundamentals had almost no similarities with those of the Great Depression. See, Blatt, "Understanding the Great Depression and the Modern Business Cycle" (2009) (Contents and Introduction) and "Great Depression Chronology" articles beginning with The Crash of '29,
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Fed Chairman Ben Bernanke, to his credit, responded to the surge in price inflation in 2011 by ending his monetary inflation efforts. The Fed's balance sheet expanded very little after the end of "QE II." He thus retained some ability to act without being immediately constrained by price inflation. He refused to implement "QE III" despite a continuation of high unemployment and a sluggish economy. Other monetary maneuvers - like "operation twist" - were of little impact but did cause vast market distortions.
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The Fed thus continued a tradition of pretending to take action - posturing - when it gets itself into a corner and simply doesn't know what else to do. It had to wait for market adjustment mechanisms to do the heavy lifting in eliminating the fundamental causes of the economic difficulties. At present, this includes the housing inventory surplus, which finally is declining closer to normal levels. To the extent that government policies - like the deluge of new regulations - are responsible for economic problems, market mechanisms cannot eliminate them until the markets deliver sufficient pain to remove the responsible governments. Clearly, throwing money at such problems in the Keynesian style cannot resolve them either.
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However, with a close election rapidly approaching, Bernanke now feels impelled to act. Monetary inflation is again being kicked into high gear. With housing market recovery already under way, the economy may well respond positively this time, and Bernanke will be sure to take credit for it. However, it will be accompanied by some significant increase in price inflation. There are already Keynesians trying to make the case that price inflation in the 4% and 5% range should be accepted to achieve the objectives of Keynesian policy. However, that level of price inflation will only be the beginning.
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The Fed's balance sheet is now loaded with financial time bombs that will begin to explode when the economy picks up some steam and interest rates have to be permitted to rise back towards market levels. Rising interest rates will also reveal that bond and other credit markets have been distorted into vast bubbles of artificially inflated values. They will reveal a wide range of other bubbles and unsustainable business plans that have been based on artificially low interest rates. This is what awaits the Fed when it finally has to address price inflation problems. But, of course, that will be after the next election, so the Fed and the other denizens of Washington, D.C. care not.

Taylor rule interest rates would have been rising during 2002 and 2003 instead of declining, and they would have inhibited the housing boom and facilitated continuation of the Great Moderation prosperity of the 1990s.

Had the Fed followed Taylor rule-type policies as it did during the 1990s, Taylor points out, basic interest rates would not have been pushed as low as one percent during 2002 and 2003. They would actually have been rising during those two years instead of declining, and they would have inhibited the housing boom and facilitated continuation of the Great Moderation prosperity of the 1990s. He easily rebuts the "worldwide savings glut" explanation for the low interest rates and rising price inflation of the 2003-2006 period. There was no "savings glut" worldwide since rising savings abroad were balanced by inadequate savings in the U.S.
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He also shows that ECB interest rates were about two percentage points below Taylor rule levels during this same period as it interacted with the federal funds rate in the U.S. The impact of ECB policies varied among the various European Union nations due to differences in their price inflation and GDP growth. Ireland, Greece and Spain varied most from Taylor rule standards and also experienced the biggest housing bubbles. Austria had the smallest deviation - and the smallest change in housing investment as a share of GDP.
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The money markets were reflecting a surge in counterparty risk, but the knee-jerk reaction of the Fed and other central banks was to just throw money at the problem, treating it as a liquidity problem in the Keynesian style.

The homeownership policies of the U.S. Government are of course also implicated in the boom and bust. See, Morgenson & Rosner, "Reckless Endangerment." Politically driven reductions in mortgage lending standards loosed a flood of subprime and adjustable rate mortgages on the economy and helped push up housing prices. Delinquencies and foreclosure rates were inevitably related to the boom and bust in housing price inflation.

"This illustrates how unintended things can happen when policy deviates from the norm. In this case, the rapidly rising housing prices and the resulting low delinquency rates [prior to the bust] likely threw the underwriting programs off track and misled many people." (Here, Taylor is basically correct but nevertheless too kind to many of the private sector mortgage finance industry participants.)

Complex mortgage-backed securities and financial support from Fannie Mae and Freddie Mac for those securities and the subprime mortgages they included are also implicated in the debacle. A proper diagnosis of the bust was essential for devising the proper policy response. (See, "The Government Directed Business Cycle," Moral Hazard & Conflicts of Interest in the Credit Crunch," "Monetary Inflation & Business Cycle Volatility," and "Understanding the Credit Crunch.") Taylor shows that the money markets were reflecting a surge in counterparty risk, but the knee-jerk reaction of the Fed and other central banks was to just throw money at the problem, treating it as a liquidity problem in the Keynesian style.

"If it was a liquidity problem, then providing more liquidity by making discount window borrowing easier or opening new windows or facilities would be appropriate. But if it was counterparty risk, then direct focus on the quality and transparency of the banks' balance sheets would be appropriate, by requiring more transparency, by dealing directly with the increasing number of mortgage defaults as housing prices fell, or by looking for ways to bring more capital into the banks and other financial institutions."

For the financial system, it was indeed a problem of elevated and unknowable risk, but it was at its most fundamental level an inventory problem involving a massive buildup of housing inventory and its related mortgage securities problems. It was a massive failure of the government's housing industrial policies that undermined some of the most vital market disciplinary mechanisms.

The problem had no relationship to those of the Great Depression. Rather, it "was due to fundamental problems in the financial sector related to risk." Misdiagnosis and emphasis on throwing money at the problem prolonged the crisis.

The widening spread between unsecured and secured interbank loans during the bust showed that the problem was primarily one of counterparty risk. "There seemed to be little, if any, role for liquidity." The problem had no relationship to those of the Great Depression. Rather, it "was due to fundamental problems in the financial sector related to risk." Misdiagnosis and emphasis on throwing money at the problem prolonged the crisis.

As FUTURECASTS has repeatedly pointed out, economic analysis must seek out the fundamental causes for economic events. Keynesian analyses based on broad aggregates such as effective demand and gross domestic product and psychological propensities are inherently incompetent. Like the Credit Crunch, the current crisis with sovereign debt is not one that can be remedied simply by throwing money at it. Nations weighed down with massive welfare state entitlements and with rigid regulatory structures that prevent growth cannot solve their sovereign debt problems. In such cases, monetary inflation just kicks the can down the road, adds the problems of price inflation to the debt problems, and increases the problems of - or renders impossible the financing of - ongoing budget deficits.
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Germany cannot throw enough money at the PIGS to resolve their problems. The ECB has already thrown trillions of euros at the problem and is still widely criticized for not doing more. This ECB policy is monetization of debt policy, not "lender of last resort" policy. See, Meltzer, History of Federal Reserve, v. 1 (1913-1951) Part I ," The Search for Monetary Stability (1913-1923)," at §A, "Understanding Money and Central Banking." PIGS problems are chronic, not "lender of last resort" short term problems.
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Typically, central bank lender of last resort policy avoids panics by liberal lending to banks on the basis of good collateral that may have been rendered temporarily illiquid due to a collapse of confidence. Such loans prevent good banks that can provide good collateral from being carried away with the weaker institutions, which are permitted to fail. As the crisis subsides, the public regains confidence and deposits and credit worthiness return to the banking system. Since this emergency lending should be at a "penalty" interest rate somewhat above normal market rates, the crisis loans would be paid off as soon as possible, and there would be no long term inflationary impact.
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Only PIGS governments can deal with the fundamental problems of their welfare state, rigid labor markets and socialist policies by enacting the reforms needed to facilitate the economic growth that alone can resolve their sovereign debt problems.

There was close correlation between the surge in interest rate spreads and market measures of counterparty risk, "demonstrating convincingly that all along the problem in the market was related to risk rather than liquidity."

The Fed's "term auction facility," ("TAF") introduced in December, 2007, permitted banks to bid directly for Federal Reserve funds without going with collateral to the Fed's discount window. This was a clear departure from "lender of last resort" policy. It was intended to reduce interest rate spreads, but after a short reduction, the interest rate spreads returned to crisis levels.
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The federal funds rate was pushed down after the middle of 2007 far more than indicated by the Taylor rule standard. The result was a doubling of oil prices and a surge in price inflation. The dollar suffered a sharp decline in international markets at that time. The decline in the dollar accounted for about $25 of the $70 increase in oil prices. The purchasing power loss from price inflation joined the contraction of purchasing power in the financial system to initiate the economic contraction that reversed the oil price rise after the middle of 2008. However, commodity price inflation reached multiple double digit levels for several years thereafter until the price inflation was reversed in 2011 by the end of "QE II" and worldwide economic slowing.
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The 2008 Economic Stimulus Act also failed to focus on underlying causes and completely failed to jump-start consumption. There was "no statistically significant increase in consumption." (The primary use of the funds was to funnel money to the states so they could put off needed pruning of their bloated state employee expenses.)
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In the fourth quarter of 2008 - a year after its initiation - the Credit Crunch bust worsened dramatically. There was close correlation between the surge in interest rate spreads and market measures of counterparty risk, "demonstrating convincingly that all along the problem in the market was related to risk rather than liquidity."
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Taylor provides an "event study" of the dramatic events and market reaction after the September 15, 2008 Lehman Brothers bankruptcy. The dramatic surge in credit market spreads did not occur until after the September 23 testimony of Fed Chairman Bernanke and Treasury Sec. Henry Paulson at a Congressional hearing. Their testimony revealed the lack of thought and analysis behind the government response. They requested a $700 billion "TARP" program in a legislative proposal that was just 2½ pages in length and that failed to include any oversight and few restrictions on the use of the funds. It was clear that the U.S. Government had no idea what it was doing and was just throwing money at the problem. It had "no predictable framework" for intervention, so the markets reacted with acute fear.

"[It] is plausible that events around September 23 actually increased risks and drove the markets down, including the public's realization, shock, and fear that the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe. At a minimum a great deal of uncertainty about what the government would do to aid financial institutions, and under what circumstances, was revealed, thereby influencing business and investment decisions at the time. Such uncertainty would have driven up risk spreads in the interbank market and elsewhere."

Banks and securities firms had little idea of how TARP funds would be used and reacted accordingly. Why did the government intervene in the Bear Stearns bankruptcy in March and later in the AIG bankruptcy in 2008 but not in the Lehman Brothers bankruptcy? Among the nation's major institutions, whose credit would receive taxpayer support and whose creditors and other counterparties would be left to bear the losses of a bankruptcy? "The more that policy makers could articulate the rationale and procedures" for an "exceptional access framework" for intervening and providing loans to major distressed institutions, the better such interventions can work.
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Rules-based monetary policy:

The quarter century prosperity called "the Great Moderation" was achieved following the 1980-1982 recession in the U.S. and in many other advanced nations by shifting from the discretionary monetarist policies of the Keynesian inflationary morass of the 1970s to rules-based monetary policy constrained by specific objectives.

It should be noted that the success of the rules-based gold standard ended after WW-I when the new Federal Reserve refused to play by the rules. Federal Reserve policies played a significant - but not a determinative - role in the boom of the 1920s and the bust of the 1930s. See, Blatt, Understanding the Great Depression," (2009), at Part II: "Government Monetary Policy." See, Meltzer, History of Federal Reserve, v. I (1913-1951), Part II, "The Engine of Inflation (1923-1933), at Section F, "The Search for an Administered Alternative."

Monetary policy authorities conquered the volatile swings in real GDP and price inflation of the 1970s by formulating monetary policy based on stated goals. The policies followed were similar to those recommended later by the Taylor rule, although the extent to which monetary authorities were actually influenced by the concepts ultimately included in the Taylor rule is not known.

"The close correlation and timing between the greater adherence of actual policy to recommended policy rules and the better economic performance can be seen in many other countries, not only in the United States. The connection between the ideas, the policies, and the results are a global phenomenon that spread quickly around the world."

Instead of the often severe recessions that struck every three or four years in the 13 years from 1969 in the U.S., the quarter century from 1982 experienced only two recessions that were about eight years apart and were relatively short and mild. It was a broad phenomenon.

"The G7 countries as a whole, for example, cut the standard deviation of real GDP in half. Not until policy again went off track - - - did we seem to be leaving the Great Moderation behind."

The end of the period of instability and crisis corresponded with changes in monetary policy by emerging market nations and the International Monetary Fund that emphasized a rules-based approach to monetary policy.

The eight years of contagious emerging market crises beginning in 1994 provide a similar picture. Once again, the end of the period of instability and crisis corresponded with changes in monetary policy by emerging market nations and the International Monetary Fund that emphasized a rules-based approach to monetary policy.
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Emerging market problems included significant reliance on debt that was denominated in hard foreign currencies in order to reduce immediate interest rate expenses. There was an inability to maintain fixed exchange rates due to "expansionary" monetary policies that generated major deficits in trade and international payments accounts. Crises occurred when currency pegs broke down and the resulting sudden devaluation rendered impossible the servicing of debts denominated in hard foreign currencies.

In addition to the shift in monetary policies, there was also a major shift in budget policies that emphasized the accumulation of the substantial dollar reserves that today provide some cushion for those nations from the sovereign debt crises of the European PIGS.

The result since 2002 has been both a reduction in emerging market crises and in the incidence of contagion from crises.

Clear monetary policy lessons have been derived by policy research into the events of the last decade.

"[Policy should] avoid currency mismatches, get inflation down and keep it down, adopt a more flexible exchange-rate policy, keep the debt-to-GDP ratio sustainable, and accumulate more foreign reserves. Many emerging market countries have learned such lessons and thus moved toward these sensible policies. Certainly reserves are higher and inflation is lower than during the eight-year crisis period."

As a result, since 2002, there has been reduction both in emerging market crises and in the incidence of contagion from crises. This coincided with the IMF adoption in 2003 of its "exceptional access framework" ("EAF") setting forth clear policy rules for responding to crisis situations. "The EAF - - - lists a set of principles or rules [with stated exceptions] that determine whether IMF support will be provided" during crisis periods. Taylor asserts that uncertainty increases the likelihood of contagion, something indicated by rational expectations modeling. One aim of the EAF was thus "to increase predictability."
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"Collective action clauses" have since become regular features of emerging market sovereign bonds. They provide a mechanism for restructuring debt at the expense of creditors should the IMF refuse to extend help when its EAF limits are exceeded. These rules are now specified so sovereign debt investors understand their risks.
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Federal Reserve policy since 2007 has treated Credit Crunch developments as liquidity problems and has abandoned rules-based monetary policy in favor of extraordinary monetary inflation and low interest rates. Because of the importance of the U.S. and the dollar's role as the world's primary reserve currency, Fed policy has pushed many developed world central banks off what would have been optimal rules-based policy. As a result, developed world central banks continue to flounder amidst the European sovereign debt crisis and the anemic recovery from the Credit Crunch recession.
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Diagnosing the Credit Crunch:

The dramatically widening money market spreads above the federal funds rate in August, 2007, revealed the onset and nature of the Credit Crunch recession. The wide spreads continued with volatile swings into 2008.
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The three month Libor-OIS spreads for the dollar, the euro and the pound all show very similar patterns of vast disruption from August, 2007.

"Libor" - the three month London Inter-bank Offered Rate by which banks extend short term funds to each other as uncollateralized loans - and "OIS" - an overnight index swap that measures the market expectation of the spread between the federal funds rate and the three-month Libor - are used by Taylor as monetary measures of the crisis. The three month Libor-OIS spreads for the dollar, the euro and the pound all show very similar patterns of vast disruption from August, 2007. However, was this due to liquidity or risk factors?
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Taylor uses three measures of counterparty risk to answer that vital question.

"By examining how these measures correlate with the Libor-OIS spread, we could determine whether rising risks were the main reason for the increased spread in the interbank markets." (Manipulations of Libor recently revealed were far too minor to materially affect Taylor's analysis.)

Credit default swaps ("CDS") provide a market measure of bank default probability. They are essentially insurance contracts against bond default. In the summer of 2007, rising CDS rates indicated that the similar increase in Libor-OIS spreads involved counterparty risk. CDS rates surged temporarily during the 2008 Bear Stearns failure and then rose again, remaining high through that summer.
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The Libor-Tibor (Tokyo Inter-bank Offered Rate) spread - reflecting interest rate spreads between major U.S. and Japanese banks - also indicated counterparty risk. Japanese banks avoided most of the problems with U.S. mortgage-related securities. Whereas Tibor rose in relation to Libor rates in Japan during the late 1990s during Japan's financial difficulties, the opposite occurred during the Credit Crunch.

"The most likely explanation is that the risks associated with interbank loans from U.S. and European banks have increased relative to those for loans among Japanese banks. Thus the Libor -Tibor spread is another measure of counterparty risk among banks in New York, London, and Frankfurt that also shows movement at the same time as the Libor-OIS spread."

"Given these results, the diagnosis that the problems in the money market, as represented by the heightened Libor-OIS spread, were mainly due to anything but risk would be questionable."

Libor-Repo spreads provide a third market-based measure - this time between unsecured Libor loans and repurchase agreement loans collateralized with U.S. Treasury securities. "Hence the spread between Libor and repo rates of the same maturity is effectively the spread between unsecured and secured loans, a natural measure of counterparty risk. This measure is also closely tied to the Libor-OIS spread." The Libor-repo spread "clearly turns up about the same time as the Libor-OIS spread."

"In sum, all three independent measures of counterparty risk are closely correlated with the Libor-OIS spread. Indeed, - - - there is not much room for any other factor. Given these results, the diagnosis that the problems in the money market, as represented by the heightened Libor-OIS spread, were mainly due to anything but risk would be questionable."

The failure of Bernanke's monetary policy:

However, central banks treated the crisis as a liquidity problem in the Keynesian style. The Fed provided significant sums to a broad range of financial institutions through Term Auction Facilities (TAF).
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By late 2008, after a year of dealing with the crisis as a liquidity problem in the Keynesian style, the focus of government efforts perforce shifted back to balance sheets.

Initial success was short lived. After initially declining somewhat, the three month Libor-OIS (overnight index swap) spread rose back to crisis levels in March, 2008, and stayed high even as TAF balances rose over $200 billion.

"As time went by and the spread continued to remain high, the idea that the TAF was reducing the spreads seemed less and less plausible. And because the TAF was designed to provide liquidity, its ineffectiveness in reducing Libor-OIS raised additional questions about the liquidity explanation of the financial stresses and confirmed the original diagnosis that the problem was risk."

These results were confirmed by John Williams and Taylor with more formal regression techniques. Taylor criticized Fed analyses that supported the effectiveness of the TAF auctions, noting that the impacts of TAF auctions on CDS rates were not always positive.
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"By the fall of 2008 there was general agreement that counterparty risk is the main explanatory factor behind the increased Libor-OIS spread." By late 2008, after a year of dealing with the crisis as a liquidity problem, the focus of government efforts perforce shifted back to balance sheets.

"If that diagnosis had been accepted a year earlier, the actions to remove bad assets or inject liquidity into the banks could have begun much earlier."

Taylor thus concludes that government policies were the primary causes of the onset and duration of the Credit Crunch.

"They caused it by deviating from historical precedents and principles for setting interest rates that had worked for twenty years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately, focusing on liquidity rather than risk. They made it worse by supporting certain financial institutions and their creditors but not others in an ad hoc way, without a clear and understandable framework. Although other factors were certainly in play, those government actions should be first on the list of answers to the question of what went wrong."

Taylor recommends that the U.S. get back on track as in the 1990s with a principled rules-based monetary policy that avoids or minimizes large discretionary policy shifts.

There were, of course, many other causes. Taylor acknowledges excessive leverage and concentration in housing market securities by private sector participants, failures in regulation by government regulatory agencies, and administration fiscal responses that were incoherent and focused on liquidity problems rather than risk.
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Taylor recommends that the U.S. get back on track as in the 1990s with a principled rules-based monetary policy that avoids or minimizes large discretionary policy shifts. For crisis periods, a predictable "exceptional access framework" for assisting financial institutions should be created.
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The author acknowledges that further analysis could alter these views, but analyses should be based on carefully documented empirical research "not ideology, personal, or partisan grounds."
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So where are we now?

By 2011, counterparty risk was again freezing important sectors of the money markets. Once again, the principle cause was excess leverage - this time primarily in the form of sovereign debt among European nations that were struggling with economic systems burdened with welfare entitlements and frozen by rigid regulatory regimes that hindered or totally prevented economic growth.
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Housing inventory excesses are by their nature slower to unwind than ordinary supply inventory excesses, but the nature of the mortgage bankruptcy process has slowed matters down further and political involvement and legal problems have brought much of it to a temporary halt from time to time.

There has been a massive adverse shift in credit worthiness, reflected in a continuous flow of ratings agency downgrades for both government and major private institutions.

Market corrective mechanisms are powerful and often deal with fundamental problems fairly quickly, allowing government policymakers to claim the effectiveness of their policies. However, if government policies are at the root of an economic contraction and are stubbornly maintained, as often occurs, then market mechanisms offer no relief until they become vicious enough to destroy the culpable governments.
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Cuurrently, democratic electorates have been churning their governments at a frantic rate. Revolutions in North Africa were more than a little related to the worldwide surges in commodity price inflation associated with the Credit Crunch period, especially with respect to wheat.
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As FUTURECASTS has explained, the Credit Crunch is basically a housing inventory and related mortgage securities bubble caused by a variety of government policies. It will come to an end after the housing inventory is brought back down to normal levels. Housing inventory excesses are by their nature slower to unwind than ordinary supply inventory excesses, but the nature of the mortgage bankruptcy process has slowed matters down further and political involvement and legal problems have brought much of it to a temporary halt from time to time.
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Nevertheless, there are increasing regions of the U.S. where the housing inventory has been brought down below a five month supply, permitting some recovery of the housing market in those areas. Elsewhere, the effects of the Credit Crunch will linger on, perhaps into the next economic contraction.
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Bernanke belatedly acknowledged the limits of his Keynesian monetary inflation policies. The results were reflected after the end of QE II in the gold and other precious metals markets and in commodity market inflation rates. Meanwhile, higher reserve requirements have been imposed on banks. Moreover, vast increases in reserves are otherwise being maintained by financial and business institutions. They are justifiably frightened by sovereign and trust debt loads ballooning out of control and the demonstrated ineptness of the economic policies of many of the world's governments.
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Thus a broad loss of "confidence" now contracts the purchasing power in financial systems - contracting the "velocity" of money and the monetary aggregates. See, Understanding Inflation. Nations that are bloated with debt are increasingly threatened by renewed economic contraction. There has been a massive adverse shift in credit worthiness, reflected in a continuous flow of ratings agency downgrades for both government and major private institutions.
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The Fed and ECB can deal with any financial problem except price inflation simply by creating more money. If they allow price inflation to develop, they will be unable to effectively respond to any major problems.

Meanwhile, European sovereign debt problems grind on. The worldwide demand for dollars for reserve purposes - a demand that has not been this high since the end of WW-II - continues. With the euro weak, these reserves are predominantly invested in U.S. treasuries. While price inflation has thus been stymied despite initial massive resort to monetary inflation, artificially low interest rates now several years in duration are generating vast bubbles in trust accounts, sovereign debt instruments, mortgage securities and high grade bonds. Weaknesses in private sector finances will be revealed when interest rates move back towards market levels, as ultimately they must. Massive weaknesses will also be revealed in the Fed's balance sheet.
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The Keynesians still clamor for further massive increases in sovereign deficit spending. They are heroically unconcerned with current levels of sovereign debt. After all, such debts can always be monetized. They offer justifications for rates of price inflation of 4% and more, so that the onset of price inflation will not hinder their monetization of debt policies. Current rates are not enough to achieve Keynesian policy success. They never will be!
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As the euro staggers, Keynesian policies have failed yet once again, leaving nations with declining economies and vast debt burdens. The Keynesians want to add debauched currencies to this list of economic horribles. The Fed and ECB can deal with any financial problem except price inflation simply by creating more money. If they allow price inflation to develop, they will be unable to effectively respond to any major problems.