Friday, May 19, 2006

En el WSJ de hoy

Adam Smith Growls

Stocks continued their weeklong plunge yesterday, selling off again at the end of the day on more inflationary fears. The way to understand this washout -- knocking 4.4% off the Dow -- is that Adam Smith is giving the U.S. financial establishment a warning.

We're using our favorite moral philosopher here as a proxy for the ruthless discipline of financial markets. They can be brutal in punishing economic mismanagement, and for several days Mr. Smith has been growling that the Federal Reserve and its easy-money cheerleaders on Wall Street and in Washington need to sober up, or there will be far worse to come. The press is calling this an "inflation scare," but for those who want to know how markets respond once a real inflation settles in, we suggest reading an economic history of the 1970s. It isn't pretty.

The 4.4%-cold shower may even prove to be beneficial if it changes the psychology in elite political and economic circles. For the last year especially, they've been ignoring signs of incipient inflation, first by trusting in Alan Greenspan's assurances, later pointing to low long-bond rates, or any other excuse to avoid facing up to a world awash in dollar liquidity and soaring gold, oil and other commodity prices. (See gold's run nearby.) This is the kind of psychology that often takes hold at this stage of an expansion, with everyone enjoying the good times and desperately afraid the Fed will spoil the fun.

But the lesson of the past 30 years is that the economic pain is far more severe the longer the Fed stays too accommodative and lets pricing pressures build. The consumer price index reading that triggered Wednesday's selloff is a lagging indicator, after all, the kind that tells you inflation is here only after it has already arrived. As Paul Volcker -- the man who finally broke the 1970s inflation -- once noted, the actual inflation data comes in months later but spot commodity prices are a real-time signal. Investors have finally begun to doubt the Fed's happy talk about a "pause" in raising interest rates or that inflationary pressures are "contained."

All of which suggests that Mr. Greenspan's successor as Fed Chairman, Ben Bernanke, is facing a rough passage. He's arrived at a Fed that has clearly made a mistake in letting inflation expectations build and has been very slow to admit it. The only questions now are the magnitude of that mistake and of the resulting financial casualties.

It's worth noting that while stocks fell yesterday, bonds rallied after comments by a couple of Fed officials that inflation may be gathering steam. "I pay a lot of attention to inflation expectations," said St. Louis Fed President William Poole, which makes us wonder what he and his colleagues have been paying attention to the last year.

The sooner Mr. Bernanke shows that he understands the problem, and has the fortitude to do something about it, the fewer casualties there will be. Sooner or later Adam Smith will take over if Mr. Bernanke doesn't.


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