FT Today: Paulson Says Crisis Sown by Imbalance

Dog bites man headline to start.

Later in the article we get this:

“Excesses . . . built up for a long time, [with] investors looking for yield, mis-pricing risk,” he said. “It could take different forms. For some of the European banks it was eastern Europe. Spain and the UK were much more like the US with housing being the biggest bubble. With Japan it may be banks continuing to invest in equities.”

This argument – already advanced by a number of economists and largely endorsed by Federal Reserve chairman Ben Bernanke – suggests that the roots of the crisis do not simply lie in failures within the financial system.

It also implies that avoiding crises in future will require global macroeconomic co-operation as well as better financial regulation and risk-management.

Global macro cooperation? Please, stop, here is the problem -- policy makers are acting as if free trade means free floating exchange rates. Nothing can be further from the truth. Check the difference in dollar depreciation against the trade weighted index of major currencies and the dollar against the trade-weighted index of "Other Important Trading Partners", namely China, India, Korea, Russia, and Brazil.

If these countries insist on keeping their currencies effectively pegged to the dollar, the Fed has to be the central banker for everyone and, in a sense, punish them for that by raising interest in the U.S. when credit growth is accelerating too fast in the U.S., not inflation. Credit growth should be the main focus of policy, and the Fed should not worry about what bubble the credit growth is feeding. Because you know what? If the Fed keeps overall credit growth within bounds, there will be no asset bubble like the housing bubble and the high tech bubble in the 1990s. And if there is one, and the Fed has kept credit growth within bounds, well then caveat emptor.

Macropolicy today, fiscal and monetary, appears to be focused on getting the economy back to where it was by keeping the dollar at uncompetitive exchange rates, swapping collapsed private debt with public credit, and allowing huge surplus nations to sustain an effectively fixed currency. We will get recovery but nothing will have been accomplished and down the road the next collapse will be worse than this one. Recessions, depressions really, are about restructuring what went wrong not just getting the economy rolling again by putting humpty dumpty back together again. And the restructuring does not mean government taking control of the means of production and the distribution of capital. Re-regulation? Absolutely. But lets make all these financial institutions smaller not bigger. More on that in a different post.

As important as recovery is, it is equally important that recovery comes with free floating foreign exchange rates everywhere or a Fed reaction function keyed to credit growth rather than inflation. In truth, we should have both but credit restraint means no inflation. And let's stop worrying about the dollar as if it's strength reflects national manhood. The mercantilist countries, including Japan, don't seem particularly concerned that their currencies trade cheap why should ours? Okay, competitive devaluation is bad, absolute truth, but like I wrote above this is not about pegging exchanges, quite the opposite, it is about letting the market decide.