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Peter Crabb: Traditional policy could help ease credit crunch

Way to go team! The Federal Reserve cut inter-bank interest rates on Wednesday by one half percent. It was a team effort, coordinated with central banks around the world, including Canada, Great Britain, Switzerland, and Germany. Rather than any new legislation the central bankers have decided their traditional policy tool could help get markets moving again.

Rates are already so low in Japan the Bank of Japan did not cut, but announced their support for the actions of other banks. Not surprisingly, the value of the yen relative to the U.S. dollar continued to rise. Lower interest rates in the U.S. and U.K. encourage faster growth in money supply, increasing the likelihood of inflation. Currency traders bought the yen and sold the dollar and the pound in response.

It’s in times like this that many call for a standard by which central banks can be restricted from increasing the money supply, and thereby lowering its value. Calls are rising for a renewed gold standard.

The argument for a gold standard is pretty straightforward – a country’s money supply depends on its stock of gold and therefore the government is physically constrained from expanding credit too far. Since credit is what got us into this mess, a gold standard should protect us from ever going there again.

But there’s no such thing as a free lunch. The tradeoff with a gold standard is that you create incentive for speculators to put their resources towards finding more gold. History reminds us of the numerous political problems associated with searching for more and more gold. Moreover, efforts to find gold divert resources from finding new technologies or other productivity enhancing processes, such as education.

If you want to control government's ability to expand credit you have to control incentives. If a central bank expands credit but the value of the currency falls relative to others (as the dollar has done the past few years), you have effectively placed a limit on credit creation. Thus, currency competition is your best enforcer. An open and active foreign exchange market, with its corresponding open and active global trade, can control credit expansion.

The recent sharp rise in the dollar relative to the euro confirms it: Credit expansion has come to an end in the U.S. Now, Europe needs action to control it there. We will see if the European governments can team up and take control of their own growing credit crisis. As they do, money will flow back to the stock markets.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.