By Denny Gulino

WASHINGTON (MNI) – Even as large earthquakes have permanent
consequences, so might huge financial disasters, as theorists try out
different post-crisis scenarios even as the U.S. political climate veers
against interventionist tactics.

What could be more unlikely than the Federal Reserve becoming the
economic “Adjustment Bureau,” twisting the dials to counteract market
vagaries much as the hit movie’s secret minders keep adjusting the
future to keep to the Plan? Or is that what the Fed is supposed to do
and just needs to be more aggressive?

The questions are being raised by what the International Monetary
Fund calls “a wholesale re-examination of macroeconomic policy
principles.” Though the IMF seems an unlikely venue for radical
reassessment not being pushed by any of its member states, its
conference earlier this month has made it safe for staid academics to
ask basic questions.

There have been some previous excursions, such as Adair Turner’s
public wondering whether the social utility of much of the Wall Streets
of the world has somehow been misconstrued. Turner, as chairman of the
Financial Services Authority, has concentrated on reinforcing
the bank system through higher capitalization.

But his March “The Turner Review” covers much more fundamental
territory with such statements as, “Trading of complex instruments in
dealing rooms by bankers who in the past have received very high
remuneration is now resulting in significant economic harm.”

Turner espouses increased international cooperation, echoing those
brave statements at the G20 back when there was more international and
U.S. momentum toward reform. Now in the U.S. the funding of Dodd-Frank
reforms has become a target for Republicans and in the most recent G-20
there was significant new caution about pursuing what earlier seemed
inevitable.

The IMF has topped Turner, however, by questioning the theoretical
underpinnings of just about everything that many still see as economic
dogma. It suggests that the aftershocks of the financial crisis are
actually still registering on the policy seismograph. It has raised
another possibility, that perhaps the 2008 crisis earthquake moved
something fundamental and policymakers and public opinion are just now
conceptualizing what’s already happened.

In the United States the gathering bipartisan congressional
epiphany, that the country is broke and mired in impossible debt burdens
— and the strains and political battles that follow — has taken the
focus away from financial system reform. At least on the surface. Under
the surface, theorists are evidently busy working out the next markets
paradigm.

Hardly hidden in some IMF archive, the path-breaking IMF staff
initiative is blazoned on the Fund’s home page. It says IMF Chief
Economist Olivier Blanchard “spurred this debate,” setting the stage for
unorthodox ideas in his pre-conference postings. The IMF has showcased
the conference results in its own separate Web site,
www.imf.org/external/np/seminars/2011/res/index.htm.

Although wide ranging, with the two-day conference examining fiscal
policy’s influence on crisis as well as that of monetary policy, the
monetary policy aspects appeared most intriguing at first glance.
Quantitative easing was both criticized as a back-door bailout for
banks and defended as a necessarily open-ended firehose to be employed
as much as necessary.

IMF Managing Director Dominique Strauss-Kahn made it clear
Blanchard had not gone rogue, using the institution to be provocative
for provocation’s sake. “The last few years have not only been a crisis
for the global economy, but also a crisis for economists,” Strauss-Kahn
— a Ph.D economist himself — said.

Of course Strauss-Kahn was also a French Socialist Party politician
as well as professor of economics. Not so well know was his stint as a
corporate lawyer. In any event, his re-think initiative may not easily
be seen in the context of anything other than left-wing wish fulfillment
fantasies. At least until the ideas generated by the conference and
their various sources across the political spectrum are examined more
closely.

Blanchard’s background at MIT, Harvard, McKinsey and Warburg Pincus
makes him less easily pigeonholed but his detractors will point out, he
too is French — among some circles in Washington, an epithet.

Early headlines about the conference centered on some authors’
observation that massive state stimulus to prevent or forestall crisis
consequences may have actually vitiated follow-on efforts to fix the
structural problems. The aid programs gave comfort, but they depleted
the stock of urgency.

Blanchard himself focused on how the very goal of monetary policy,
to control inflation, may be short-sighted and too narrow. After all,
even with inflation neutralized, there remain global imbalances. There
remain mountains of reserves in some countries and growing caverns of
debt in others and in between, often rigid exchange rate regimes that
are a barrier to balancing.

In the U.S., with Dodd-Frank reforms just becoming barely tangible,
big banks have concentrated their holdings even more. If they were too
big to fail or regulate before, they are bigger now.

So, Blanchard summarized, “The crisis has clearly shown both the
limits of markets and the limits of government intervention.”

The “limits of markets” is the kind of food for thought that
analysts and columnists tend to devour whole and it was evident in
Saturday’s pages of the influential Financial Times that a seed has been
planted.

John Authers, the veteran journalist and editor of the FT’s widely
read “Lex” column, headlined his column, “We need new models in an
uncertain world.”

While focusing on the disruption that Mother Nature can cause to
economic models, specifically the Japanese earthquake and tsunami,
Authers quickly leapt to the observation, “The debate over how to
re-regulate [markets and banks] to avoid another financial crisis is
urgent and it cannot conclude without resolving the philosophical
problem that economics’ most basic assumption is flawed.”

He pitted efficient markets theory against “behavioural
psychology,” which finds human beings and their herd instinct makes
markets “predictably inefficient.”

He cited Amar Bhide, the prolific Tufts University and Fletcher
School of Law and Diplomacy lecturer who has written a new book about
the merits of “judgment” as opposed to markets’ automaticity.

He also cited Roman Frydman, whose latest book furthers a
campaign to jettison the rational expectations hypothesis. His coauthor
Michael Goldberg and he have worked out something called Imperfect
Knowledge Economics which rejects quantitative predictions of market
outcomes in favor of qualitative predictions. They claim their approach
works particularly well, for instance, in foreign exchange markets.

The list of “rethinkers” is already much, much longer. Years of
incremental argument and counterargument lie ahead. And long after the
Fed’s current $600 billion of quantitative ease is just a memory, the
arguments may narrow to which policy apparatus is capable of applying
“judgment” to markets. The questions may become, which institution
actually was in the position of being able to step in to fine-tune
recovery. Which institution has even a mechanism to act in time, or keep
acting after governments expend all their bullets.

As Adam Posen, a member of the BOE’s Monetary Policy Committee and
a senior fellow at a Washington think tank, offered the IMF conference:
“This is not just about getting through a bad patch, being impatient
about a return to growth and employment. The policy challenge is about
getting out of a self-perpetuating negative outcome that would erode
many of our children’s future.”

** Market News International Washington Bureau: 202-371-2121 **

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