The Fed's faulty approach to asset bubbles
I want to follow up on my Bernanke/subprime mortgage post with some bigger-picture thoughts. We have now seen a massive, easy-money fueled tech/dot-com bubble and bust AND a massive, easy-money fueled housing/mortgage bubble and bust within a span of just of 10-12 years.
In both instances, many private analysts practically begged the Fed to step in and do something before the booms inflated into outright bubbles. But in both instances, the Fed failed to wield its interest rate or regulatory hammers hard enough or early enough to get things under control. We are all suffering the consequences of those failures.
Why has the Fed failed? I believe it's because policymakers are still clinging to this outdated notion that they shouldn't do anything to attack asset bubbles preemptively. Fed Governor Frederic Mishkin tried to defend the logic of that approach back in January (you can read my rebuttal here, if you like). And just yesterday, Fed Vice Chairman Donald Kohn reiterated roughly the same thing.
Kohn's speech really got my blood boiling. In short, he said the Fed shouldn't target asset prices ... unless, of course, we have a "systemic event." In plain English, that's when asset prices go down and credit seizes up. If that happens, Kohn asserts, the Fed should just throw its "no asset intervention" principle completely out the window and flood the markets with easy money. These are his comments (with my emphasis added):
"Before discussing what we are doing and what we should be doing, I want to take a few minutes to call attention to some limits and constraints on our actions. We need to accept that accidents will happen -- that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises. But we cannot and should not try to prevent this process through a monetary policy that puts special emphasis on stabilizing asset prices or through regulatory policies that limit access to markets by qualified participants or that attempt to restrain competition materially. Monetary policy that proactively leans against asset price movements runs a considerable risk of yielding macroeconomic results that fall short of maximum sustainable growth and price stability. Regulatory policies that try to prevent failures of core participants or others under all conceivable circumstances will tend to stifle innovation and reduce our economy's potential for long-run growth.
"Systemic events in market-based financial systems are perhaps more likely to involve price fluctuations and abrupt changes in market liquidity than are systemic events in depository-based financial systems. But that is not really bad news because such events can more readily be countered by macroeconomic policy instruments than could old-fashioned crises of depository intermediation. Supplying additional liquidity and reducing borrowing costs can greatly ameliorate the effects of market events on the economy, and those types of macroeconomic interventions will carry less potential for increasing moral hazard than would the discount window lending that was a prominent feature of crisis management when depositories funded more credit."
How can you possibly argue ... with a straight face ... that flooding markets with easy money whenever things go wrong doesn't cause "moral hazard?" How can you possibly just stick your head in the sand whenever asset prices are exploding, credit growth is getting out of control, and lenders are taking excessive risk -- due to a principle of non-intervention in the asset markets -- then turn around and intervene when asset prices go down? AAaarrrggghhhhh. I need to go for a walk.
In both instances, many private analysts practically begged the Fed to step in and do something before the booms inflated into outright bubbles. But in both instances, the Fed failed to wield its interest rate or regulatory hammers hard enough or early enough to get things under control. We are all suffering the consequences of those failures.
Why has the Fed failed? I believe it's because policymakers are still clinging to this outdated notion that they shouldn't do anything to attack asset bubbles preemptively. Fed Governor Frederic Mishkin tried to defend the logic of that approach back in January (you can read my rebuttal here, if you like). And just yesterday, Fed Vice Chairman Donald Kohn reiterated roughly the same thing.
Kohn's speech really got my blood boiling. In short, he said the Fed shouldn't target asset prices ... unless, of course, we have a "systemic event." In plain English, that's when asset prices go down and credit seizes up. If that happens, Kohn asserts, the Fed should just throw its "no asset intervention" principle completely out the window and flood the markets with easy money. These are his comments (with my emphasis added):
"Before discussing what we are doing and what we should be doing, I want to take a few minutes to call attention to some limits and constraints on our actions. We need to accept that accidents will happen -- that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises. But we cannot and should not try to prevent this process through a monetary policy that puts special emphasis on stabilizing asset prices or through regulatory policies that limit access to markets by qualified participants or that attempt to restrain competition materially. Monetary policy that proactively leans against asset price movements runs a considerable risk of yielding macroeconomic results that fall short of maximum sustainable growth and price stability. Regulatory policies that try to prevent failures of core participants or others under all conceivable circumstances will tend to stifle innovation and reduce our economy's potential for long-run growth.
"Systemic events in market-based financial systems are perhaps more likely to involve price fluctuations and abrupt changes in market liquidity than are systemic events in depository-based financial systems. But that is not really bad news because such events can more readily be countered by macroeconomic policy instruments than could old-fashioned crises of depository intermediation. Supplying additional liquidity and reducing borrowing costs can greatly ameliorate the effects of market events on the economy, and those types of macroeconomic interventions will carry less potential for increasing moral hazard than would the discount window lending that was a prominent feature of crisis management when depositories funded more credit."
How can you possibly argue ... with a straight face ... that flooding markets with easy money whenever things go wrong doesn't cause "moral hazard?" How can you possibly just stick your head in the sand whenever asset prices are exploding, credit growth is getting out of control, and lenders are taking excessive risk -- due to a principle of non-intervention in the asset markets -- then turn around and intervene when asset prices go down? AAaarrrggghhhhh. I need to go for a walk.
posted by Mike Larson at
1:21 PM
1 Comments:
Well Mike, here we are almost 18 months later and Bernanke / Paulson are still on the same track. Arrgghh, indeed. Interesting, though, along with the House rejected easy money scheme, the Fed did use the discount window somewhat. Good article re the current mess and the totally inadequate risk evaluation of the "originate and distribute" market on the www.levy.org website at Bard College.
Jules
By
Anonymous, at September 30, 2008 at 12:25 AM
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