Are you one-handed?

VoXEU.org, as the name suggested is a EU assisted portal set up by the Centre for Economic Policy Research (www.CEPR.org) in conjunction with a consortium of national sites. Vox aims to promote research-based policy analysis and commentary by leading scholars. But the website forces the authors to limit the commentary to maximum 1500 words a piece, making it accessible to a commoner.

There are perhaps a hundred explanations for the crisis in its aftermath (and before the crisis too, but who listens when the going is fine?) but a couple of ideas are worth highlighting.

Why did the Fed pursue a loose monetary policy for a long time?
It is said rightly that Fed kept a low interest rate regime for too long, contributing to asset bubbles. But why did it do that? Axel Leijonhufvud, Professor of Economics at UCLA, attributes the failure to inflation targeting, which is long heralded as the central bank's main job. In spite of the loose monetary policy, inflation stayed low for almost 5 years, because the developing economies kept their home currencies from appreciating and flooded the US markets with cheap imports.

Axel goes on to argue that while the imports kept the core inflation down, the Fed didnt recognise the asset price inflation it helped create(Alan Greenspan called it Asset froth instead of bubble, the typical George Orwell-coined-doublespeak).

In Age of Turbulence (the book was released when its author Alan Greenspan still had a reputation) Greenspan says how disturbed he was seeing the long rates (10 year GSec rates, the market's inflationary expectation) go down when the Fed started to tighten Monetary policy in June 2004 (He thought the fall was because of a global disinflation phenomenon, owing to rising productivity which put a lid on wages. He says and I quote, '..One recent evidence is the extraordinary number of labor contracts with 5-6 years maturities. We never had labor contracts of more than 3 years duration in the past 30-40 years').

To see how liquidity creates asset bubbles, we should recognise that financial market works differently from a Bread market, in that the demand and supply doesnt balance by price discovery, but the effects of high prices and high leverage are reinforcing. A typical investment bank had a capital of 1$ and borrowed $24 to buy assets worth $25. (the leverage of 24 might look eye-popping, but Lehman Brothers operated at a peak leverage of 32 in the First Quarter 2008). Assuming the assets earned 0.5% more than liabilities, the Return on equity was 12.5%. Since everyone chases the return, the spread of 0.5% narrows significantly, characterized by low risk premiums.

The only was to maintain RoE was to either hoard up more leverage, or chase riskier asset classes. Either actions have a reinforcing effect on prices. This is different from Bread market where the demand cools when prices rise.

Leverage works both ways- a drop in about 20% value in a portfolio where 20% of the assets are in MBS can wipe out capital (Case shiller home price index was down 23% from 2006 levels).

The solutions suggested aren't path breaking- more capital and more reserves to constrain leverage, but that's not my point. What do you do when you read two interpretations for the same phenomenon and both looks fine at that moment? Am I suffering something similar to Harry Truman's one-handed-economist syndrome?