Tuesday, September 29, 2009

New Paper on the Greenspan and Bernanke Fed

John Ryan and Ryan Koronowski have a nice survey paper on the Greenspan and Bernanke Fed (Hat tip to Mark Thoma). The paper explains in a straightforward manner how the Fed works and considers its policy actions during the tenure of Greenspan and Bernanke. The paper draws upon the work of William White, Claudio Borio, and the other folks at the BIS as well as Martin Wolf. It provides a nice complement to David Wessel's "In Fed We Trust" and, among other things, would work well in a money and banking course.

Here is one excerpt from the paper that sounds like something I would say:
White argues that price stabilization which tries to avoid periods of deflation (what is characteristic for definitions of price stability as a central bank’s target) sometimes may be too expansionary and it may lead to an asset price bubble. This may happen in a situation of “good deflation” when prices decrease as an effect of some positive supply shocks such as rapid growth of productivity or – as recently – globalization. However, it is interesting in this context to ask to what degree monetary policy should be more accommodative in case of “bad deflation” – one induced by a financial crisis and falling demand - without risking it may turn out to have been too easy.
Another way of saying this is that the Fed should stabilize nominal spending. Rapid productivity gains create deflationary pressures. If such productivity gains are accompanied by an easing of monetary policy to offset the downward price pressures there will be a surge in nominal spending. On the other hand, deflationary pressures could also arise from a collapse in nominal spending. Fed policy should avoid both types of swings in nominal spending because such swings in conjunction with nominal rigidities (e.g. sticky prices) would cause output to move outside its sustainable or natural rate level. As I have noted before, though, the Fed failed to do this in the 2003-2005 period and more recently in the late 2008-early 2009 period. Stabilize nominal spending or more macroeconomic bust!

Monday, September 28, 2009

Making the Case for Financial Innovation

In a refreshing change, Robert Shiller makes the case for financial innovation. Along the way he lists some ideas about where financial innovation could go. I like this one in particular:
I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.
Financial innovation may one day actually serve to prevent financial crisis from ever emerging

Putting Klingonomics to the Test

Arnold Kling has been promoting a macroeconomic theory he calls "Recalculation" which takes a controversial view on the efficacy of monetary policy. You can read his discussion of recalculation macro here, here, and here. Within these discussions he summarizes his view of monetary policy as follows:
In the short run, the economy is going its own way, regardless of monetary policy. Higher M leads to lower V, and vice-versa. In the long run, a significant change in the rate of money creation causes a similar change in the rate of inflation. However, the lag is long and the effect on the rate of Recalculation is small and of indeterminate sign[.]
As this and other passages from his postings show, Kling makes three controversial assertions about monetary policy in his recalculation macro theory. They are as follows:
(1) Monetary policy has no effect on expectations in the short-run.

(2) Monetary policy has no effect on nominal economic activity in the short run.

(3) Monetary policy has no effect on real economic activity in the short run.
Bill Woolsey has been all over Kling's case for making these assertions and the assumptions behind them. I will speak in a moment to Woolsey's critique but for now I want to see what the data says about the assertions (1) - (3).

Number (1) touches on an important question: can the Fed influence expectations about the future in such a way as to shape current economic behavior? Standard macro theory says yes--it is the reasoning behind the current arguments for why the Fed should be explicitly targeting some positive rate of inflation now. Kling, however, does not buy it. In order to test this question empirically, I took the monthly expected inflation series implied by the difference between the nominal 10-year Treasury yield and the 10-year TIPs yield and put it in a vector autoregression (VAR) along with the monthly GDP series from macroeconomic advisers. Nominal GDP was turned into an annualized monthly growth rate and the data used runs from 1999:1 through 2007:9. More data would have been helpful, but TIPs only start in the late 1990s. (Technical note: both series were in rates so no unit root problems, 13 lags were used to eliminate serial correlation, and corporate bond spreads were included as a control variable for the financial crisis). The two figures below show what the typical responses of expected inflation and nominal GDP to the typical sudden change or shock to expected inflation over the sample. The solid line shows the point estimate while the dashed lines show two standard deviations around the point estimate. Upon impact, the shock causes expected inflation to jump 16 basis points and occurs as the level of nominal GDP increases by 1.16 percent. In other words, a sudden positive change in expected inflation is associated with an increase in current nominal spending. Both effects persist but eventually become insignificant about 14-15 months later. (Click on figures to enlarge.)





Now presumably the change in 10-year expected inflation comes from a expected change in monetary policy, but just to be sure and to fully address (2) and (3) I have posted below some figures from another VAR I did that looks at the effect of unexpected changes or shocks to the monetary base for the period 1960:3 - 2008:2. This is a larger VAR that controls for more things. (This figure is actually an excerpt from a series of VARs I did in response to Nick Rowe's post on monetary policy and debt.) Here, the monetary base is shocked 1%. Note how all the real variables increase on impact. In other words, an unexpected positive increase in the monetary base historically has led to an increase in the short run of real economic variables. As predicted by theory, the effect of the monetary base shock eventually wears out--money becomes neutral. (Note that the price level is implicitly in these figures too: it is difference between real money and money. Here, there is a permanent effect)




So the assertions (1), (2), and (3) are empirically falsified. Of course we did not need my VARs to know this. There is already a lot of empirical evidence out there that reaches a similar conclusion. Moreover, Bryan Caplan notes numbers (1) and (2) fly in the face of everything we know from hyperinflation experiences. So why make such assertions? Bill Woolsely explains that Kling's assertions can work if prices are sticky in the short run, real income is determined by productive capacity, and real money demand is not affected by real income. As Bill Woolsely notes, this last assumptions is incredibly wrong, as many empirical studies have demonstrated over the past 50 years.

In light of the evidence I say it is time for Arnold Kling to join the ranks of the monetary disequilibrium bloggers.

Update 1:Here are some definitions to add clarity to the figures above. The real stock price series is the real S&P 500, the debt series is financial sector debt to GDP, the money supply is the monetary base, and the real money balance series is the monetary base divided by the CPI.

Update 2: Josh Hendrickson provides a nice follow up to the issues raised here while Arnold Kling assails my use of the "Dark Age Macroeconomic"-based VAR.

Thursday, September 17, 2009

Should Monetary Policy "Lean or Clean"?

That is the title of a new paper by William White, one of the few influential economists who saw the crisis coming and tried to warn others. Here is the abstract:
It has been contended by many in the central banking community that monetary policy would not be effective in "leaning" against the upswing of a credit cycle (the boom) but that lower interest rates would be effective in "cleaning" up (the bust) afterwards. In this paper, these two propositions (can't lean, but can clean) are examined and found seriously deficient. In particular, it is contended in this paper that monetary policies designed solely to deal with short term problems of insufficient demand could make medium term problems worse by encouraging a buildup of debt that cannot be sustained over time. The conclusion reached is that monetary policy should be more focused on "preemptive tightening" to moderate credit bubbles than on "preemptive easing" to deal with the after effects. There is a need for a new macrofinancial stability framework that would use both regulatory and monetary instruments to resist credit bubbles and thus promote sustainable economic growth over time.

Does the Equation of Exchange Shed Any Light on the Crisis?

James Hamilton thinks the answer is no. In his reply to Scott Sumner's lead article at Cato Unbound, he questions Sumner's use of the identity MV = PY to explain the collapse of nominal spending over the past year. (In this equation M = money supply, V = velocity or the average number of times a unit of money is spent, P = price level, Y = real GDP, and PY = nominal GDP.) Hamilton contends the only meaningful use of the identity is to determine velocity (i.e. V=PY/M) and even then it is not totally reliable since it can vary based on the measure of money one uses. I believe, however, Hamilton under appreciates the insights this identity can shed on the crisis. It may not provide precise policy recommendations, but it does provide a starting point from which to think analytically and empirically about recent economic developments.

So what does this identity tells us about the crisis? To answer this question we first need to expand the identity a bit. To do so, note that the money supply is the product of the monetary base, B, times the money multiplier, m or

M = Bm.

Now substitute this into the equation of exchange to get the following:

BmV = PY.

Now we have an identity that says the sources of nominal spending are the monetary base, the money multiplier, and velocity. With this identity in hand we can asses the contribution of these three sources to the dramatic decline in nominal spending in the past year. Using MZM as the measure of money (see here for why MZM is preferred over M1 and M2) and monthly nominal GDP from Macroeconomic Advisers to construct velocity, the three series are graphed below in levels (click on figure to enlarge):


This figure indicates that declines in the money multiplier and velocity have both been pulling down nominal GDP. The decline in the money multiplier reflects (1) the problems in the banking system that have led to a decline in financial intermediation as well as (2) the interest the Fed is paying on excess bank reserves. The decline in the velocity is presumably the result of an increase in real money demand created by the uncertainty surrounding the recession. This figure also shows that the Federal Reserve has been significantly increasing the monetary base, which should, all else equal, put upward pressure on nominal spending. However, all else is not equal as the movements in the money multiplier and the monetary base appear to mostly offset each other. Therefore, it seems that on balance it has been the fall in velocity (i.e. the increase in real money demand) that has driven the collapse in nominal spending.

To get a better sense of what is happening with theses series note that log of the expanded equation of exchange can be stated as follows:

B+m+V = P+Y,

Now if we take first differences of the the quarterly log values of the series in the above identity we get a quarterly growth rate approximation. (Note, this approximation is not very good for large differences like the one for the monetary base in 2008:Q4.) Below is a table with the results in annualized values (Click to enlarge):


This table confirms what we saw in the levels: a sharp decline in velocity appears to be the main contributor to the collapse in nominal spending in late 2008 and early 2009 as changes in the monetary base and the money multiplier largely offset each other. It is striking that the largest run ups in the monetary base occurred in the same quarters (2008:Q3, 2008:Q4) as the largest drops in the money multiplier. If the Fed's payment on excess reserves were the main reason for the decline in the money multiplier and if the Fed used this new tool in order to allow for massive credit easing (i.e. buying up troubled assets and bringing down spreads) without inflation emerging, then the Fed's timing was impeccable. Unfortunately, though, it appears the Fed was so focused on preventing its credit easing program from destabilizing the money supply that it overlooked, or least underestimated, developments with real money demand (i.e. velocity). As a consequence, nominal spending crashed.

Now maybe this is self evident to some, but I find the above information from the equation of exchange useful as a starting point for discussing what went wrong and where to go from here.

Friends Don't Let Friends Mix Say's Law with Money

Nick Rowe recently noted that John Cochrane, in his rebuttal to Paul Krugman, effectively invokes Say's law with this sentence:
Paul’s Keynesian economics requires that people make plans to consume more, invest more, and pay more taxes with the same income.
Cochrane's point is that it is impossible to have total planned expenditures exceed total income. This line of thinking or Say's law, taken to its logical conclusion, implies it is impossible to have a general, economy-wide glut since (1) total income must equal total planned expenditures and (2) total income comes from the production of goods and services upon which total expenditures are spent. (i.e. total planned expenditures = total income = total value of production). Obviously, history has not been kind to this proposition. As Nick notes, this is because Say's law assumes a barter economy and ignores the complications found in a money economy. Here to explain these complications is Leland Yeager (Source: The Fluttering Veil: Essays on Monetary Disequilibrium, p.4-6):
Say's law, or a crude version of it, rules out general overproduction: an excess supply of some things in relation to the demand for them necessarily constitutes an excess demand for some other things in relation to their supply...
The catch is this: while an excess supply of some things necessarily mean an excess demand for others, those other things may, unhappily, be money. If so, depression in some industries no longer entails boom in others...

[T]the quantity of money people desire to hold does not always just equal the quantity they possess. Equality of the two is an equilibrium condition, not an identity. Only in... monetary equilibrium are they equal. Only then are the total value of goods and labor supplied and demanded equal, so that a deficient demand for some kinds entails and excess demand for others.

Say's law overlooks monetary disequilibrium. If people on the whole are trying to add more money to their total cash balances than is being added to the total money stock (or are trying to maintain their cash balances when the money stock is shrinking), they are trying to sell more goods and labor than are being bought. If people on the whole are unwilling to add as much money to their total cash balances as is being added to the total money stock (or are trying to reduce their cash balances when the money stock is not shrinking), they are trying to buy more goods and labor than are being offered.

The most striking characteristic of depression is not overproduction of some things and underproduction of others, but rather, a general "buyers' market," in which sellers have special trouble finding people willing to pay more for goods and labor. Even a slight depression shows itself in the price and output statistics of a wide range of consumer-goods and investment-goods industries. Clearly some very general imbalance must exist, involving the one thing--money--traded on all markets. In inflation, an opposite kind of monetary imbalance is even more obvious.

Also see Brad DeLong's comments on this issue.

Tuesday, September 15, 2009

Targeting the Forecast

Over at Cato Unbound, Scott Sumner is leading a discussion on the conduct of monetary policy during this crisis. True to form, he is arguing the Fed was effectively too tight in the second half of 2008 and, as a result, caused aggregate demand to collapse during that time. He also makes the case that the nominal spending collapse of 2008 could have been avoided if the Fed had been targeting the forecast. His argument for targeting the forecast is posted below. Jim Hamilton, George Selgin, and Jeffrey Hummel are scheduled to reply to Sumner's lead article.
Lars Svensson has advocated a policy of targeting the forecast — setting the central bank’s policy instrument at the level most likely to hit its policy goal. Thus, if a central bank had a goal of two-percent inflation, it should set the fed funds rate at a level where its own forecasters were forecasting two-percent inflation. Once one starts to think of monetary policy this way, any other policy seems unacceptable. After all, why would any central bank ever want to adopt a policy stance that was expected to fail.

[...]

I have advocated a policy where the Fed pegs the price of a 12-month forward NGDP futures contract and lets purchases and sales of that contract lead to parallel open market operations. In essence, this would mean letting the market determine the monetary base and the level of interest rates expected to lead to five-percent NGDP growth. When I first proposed this idea in the 1980s, I envisioned the advantage in terms of traders observing local demand shocks before the central bank. The logic behind this idea is often called “the wisdom of the crowds.” But I no longer see this as its primary advantage. Although last fall the market forecast turned out to be far more accurate than the Fed’s forecast, in general the Fed forecasts pretty well.

This crisis has dramatized two other advantages to futures targeting, each far more important that the “efficient markets” argument. One advantage is that the central bank would no longer have to choose a policy instrument. Their preferred instrument, the fed funds rate, proved entirely inadequate once nominal rates hit zero. Under futures targeting each trader could look at their favorite policy indicator, and use whatever structural model of the economy they preferred. A few years ago I published this idea under the title “Let a Thousand Models Bloom.” I am not an “Austrian” economist, but this proposal is very Austrian in spirit. (And my preferred policy target, NGDP, is also the nominal aggregate that Hayek thought was most informative.)

Only last fall did I realize that there was another, even more powerful advantage of futures targeting-credibility. The same people forecasting the effects of monetary policy would also be those setting monetary policy. Under the current regime, the Fed sets policy and the market forecasts the effects of policy. To consider why this is so important, consider the Fed’s current dilemma. They have already pumped a lot of money into the economy, but prices have fallen over the past year as base velocity plummeted. Certainly if they pumped trillions more into the money supply at some point expectations would turn around. But when this occurred, velocity might increase as well, and that same monetary base could suddenly become highly inflationary. This problem does not occur under a futures targeting regime. Rather, the market forecasts the money supply required to hit the Fed’s policy goal, under the assumption that they will hit that goal. Today we have no idea how much money is needed, because the current level of velocity reflects the (quite rational) assumption that policy will fail to boost NGDP at the desired rate.

I especially look forward to Selgin's reply since he too is an advocate of nominal income targeting.

Monday, September 14, 2009

Revving Up the Great Depression Debate, Once Again

What ended the Great Depression? Christian Romer made the case in a famous article that it was FDR's unconventional monetary policy--not sterilizing the gold inflows from Europe and devaluing the dollar in terms of gold--and not fiscal policy that ended the Great Depression. More recently, Gauti Eggertsson argued it was not unconventional monetary policy itself but rather a change in expectations from a number of policies that ended the Great Depression. His view is that FDR's monetary and fiscal policies changed deflationary expectations to inflationary ones and in so doing got nominal spending going again. While Eggertson's explanation is intuitive, it goes against Romer in arguing fiscal policy mattered too. It also makes a provocative claim that the National Industrial Recover Act (NIRA) played an important part in ending the deflationary expectations. The implication, then, is that any immediate output loss generated by NIRA cartel and monopoly-like policies was more than offset by the increase in output generated by the change in inflation expectations the NIRA helped create.

Eggertson's paper provides a clever but controversial interpretation of this period. And Steven Horwitz is not buying it one bit. He has a new article in Econ Journal Watch that questions Eggertson's paper. He specifically says Eggertson has his basic history wrong for this period and thus his DSGE model--the source of the paper's findings--has little merit. Horwitz paper is interesting and is sure to rev up the Great Depression debate once again. In case you missed this long-running debate in the blogosphere here was my past attempt to summarize it. (Click on picture to enlarge.):


Friday, September 11, 2009

Krugman Takes Some Heat

The Paul Krugman essay in the New York Time magazine has generated many replies. Here are are three good ones, two of which came up with the same clever title:

(1) How Did Krugman Get it So Wrong? 9/4/09 - Scott Sumner

(2) How Did Krugman Get it So Wrong? 9/10/09 - John Cochrane

(3) Economists Got it Wrong, But Why? 9/10/09 - David Altig

The Fed as a Monopsony

The Federal Reserve is sometimes pejoratively called a monopoly producer of money. Now it is also being called an a monopsony (or something close to it) in the macroeconomic labor and thought market. Writing in the Huffington Post, Ryan Grim makes the case that Fed has undue influence on what macroeconomic topics get an airing in top professional outlets because (1) the Fed hires a large number of macroeconomists and visiting scholars, (2) it has its staff strategically located on the editorial boards of top money and macro journals, (3) it has many sympathetic alum strategically placed, (4) it causes non-Fed economists to be mindful of what they say so as to not shut off future opportunities with the Fed, and (4) it funds many scholarly conferences on macroeconomic issues. Here is Grim:
The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed's thrall, the economists missed it, too.

[...]

One critical way the Fed exerts control on academic economists is through its relationships with the field's gatekeepers. For instance, at the Journal of Monetary Economics, a must-publish venue for rising economists, more than half of the editorial board members are currently on the Fed payroll -- and the rest have been in the past.
While Grim's article is an interesting read, a more scholarly, even-handed critique of the Fed's influence was done by Lawrence H. White back in 2005 for the journal Econ Journal Watch. Here is his abstract:
The Federal Reserve System is a major sponsor of monetary economics research by American economists. I provide some measures of the size of the Fed’s research program (both inputs and published outputs) and consider how the Fed’s sponsorship may directly and indirectly influence the character of academic research in monetary economics. In particular, I raise the issue of status quo bias in the Fed-sponsored research.
Like Ryan Grim, Lawrence H. White concludes that Fed does have some monopsony-like power in the macroeconomic labor and thought market. This critique makes sense, but it does not stop folks like me from doing research that questions the Fed's policies. And if all else fails, I have this blog... oh wait, I have to get tenure first!

The Fate of the National Debt

Bruce Bartlett has an interesting article in Forbes where he tackles the question of how much national debt is too much for the United States. He notes that even with the help of history and theory the answer to this question is not straightforward:
The latest budget projections show the national debt rising from $5.8 trillion last year to $7.6 trillion this year and $14.3 trillion in 2019. According to the Congressional Budget Office (CBO), the debt will rise from 40.8% of the gross domestic product in 2008 to 53.8% in 2009 and 67.8% in 2019.

This raises the question of how much debt is too much...This is a surprisingly difficult question to answer. The only time in American history that the debt has been as large as projected was during World War II and the decade following it. The Civil War caused the debt to rise from 1.4% of GDP in 1860 to 31% of GDP in 1867. During World War I, the debt rose from less than 3% of GDP in 1915 to about a third of GDP in 1919. On the eve of World War II, the debt was a little more than 50% of GDP, rising to 122% of GDP by 1946.

[...]

Insofar as we can isolate the impact of the national debt on the economy, it is hard to find it. One reason might be that in the past, people understood that the debt was only temporarily high and would decline sharply as soon as the wars ended. Indeed, the debt did decline after every war in American history. Arguably, the budget surpluses of the Clinton years, which saw the debt/GDP ratio fall from 49% to 33%, resulted largely from the end of the Cold War, which permitted a large cut in defense spending... [O]ne problem we have going forward is that we are not in a war of the magnitude that led to sharp rises in debt in the past. Therefore, we cannot anticipate that the debt will fall with the end of hostilities...
Okay, but if push came to shove at least the United States has the option to inflate its debt away... right?
Although it is thought that inflation is an effective way of reducing the burden of debt, this is no longer true. For one thing, a declining portion of the debt is financed with long-term securities. Today, just 3% of the debt consists of bonds with maturities of 20 years or more; 10 years ago, the proportion was four times greater. To the extent that the debt consists of short-term securities that must constantly be rolled over, inflation does nothing to erode its value because interest rates just rise to compensate, raising interest payments and borrowing, thus maintaining the real value of the debt... Inflation will also cause the dollar to fall on international markets, which will cause foreigners to dump their bonds. With foreigners now owning more than 50% of the privately held debt, this may force the Treasury to issue foreign currency denominated bonds. At this point, our finances will effectively be controlled by foreigners and the International Monetary Fund (IMF)
Barlett, himself a Republican, goes on to discuss his fear that the current Republican leadership is so averse to any tax increase (and presumably they would be politically incapable of scaling back spending) that they would rather default than raise taxes. They would also make life difficult for any Democrat that tried to do so. Given these political realities, he concludes that possibility of a U.S. default is not out of the question.

Thursday, September 10, 2009

The Great Nominal Spending Crash

Was monetary policy actually tight in the latter half of 2008? Scott Sumner has been arguing for some time that the answer is yes and has nicely summarized his views in this Vox Eu article. He gives a list of indicators to make his case, but leaves out what I think is the most damning evidence: the dramatic collapse in nominal spending at this time. A key premise behind his thinking is that monetary policy should stabilize nominal spending in order to ensure macroeconomic stability. Consequently, to the extent nominal spending dramatically decreases (increases) it must be the case that monetary policy is too tight (too loose). Below is a figure that documents this collapse in nominal spending--as measured by the annual growth in final sales to domestic purchasers--in the second half of 2008. The figure also documents some other well-known macroeconomic periods. I have taken the liberty to rename these periods using nominal spending labels (Click on the figure to enlarge.)

Wednesday, September 9, 2009

Ending the Bubble-Bust-Bailout Cycle

Writing in the New Republic, Simon Johnson and Peter Boone express grave concern that we have made it through this economic crisis only to be setting ourselves up for another one:
[T]he Fed may well have mitigated our current crisis by sowing the seeds for the next one... Our banks have gotten into the habit of needing to be rescued through repeated bailouts. During this crisis, Bernanke--while saving the financial system in the short term--has done nothing to break this long-term pattern; worse, he exacerbated it. As a result, unless real reform happens soon, we face the prospect of another bubble-bust-bailout cycle that will be even more dangerous than the one we’ve just been through.
Johonson and Boone argue that the next bubble-bust-bailout is just part of a pattern that the Fed has inadvertently played into since the 1970s:
Since the 1970s, successive financial crises have required ever more dramatic reactions from the Fed. Every time there is a potential financial meltdown, the Federal Open Market Committee quickly cuts short-term interest rates. These cuts have become larger and larger over time, now essentially taking interest rates to zero. Each round of interest-rate cuts has made sense when a given crisis breaks. But these cuts--which effectively function as bailouts for banks that have gotten into trouble--often helped bring about the next financial crisis. And the crises are getting larger, not smaller, over time.
They go on to document how every Fed chairman since the late 1970s, including the saintly Paul Volker, has been a contributor to this cycle. They also argue that the currently proposed reform of the financial system will not end this cycle:
In June 2009, Treasury Secretary Timothy Geithner unveiled the administration’s plans for reforming our financial sector and preventing a major crisis from happening again. The cornerstone of the proposal is to (slightly) reduce the number of agencies carrying out regulation, and to give new powers to the Fed.

Unfortunately, these changes are unlikely to work. They do not alter the enormous incentive our banks have to take excessive risks. They don’t address the fact that strong financial groups can lobby our lawmakers and beat down regulators until they are largely ineffective. And they don’t affect our propagation mechanism: The printing presses at the Fed remain open and available for when the next crash comes, and that makes creditors confident that they can lend without risk to our heavily leveraged financial sector. As long as this combination remains in place, today’s financial executives fully understand that the party goes on.
Their solution to ending this cycle is to sharply raise capital requirements at banks, make managers and boards of directors at financial institutions personally liable to some extent for their companies, regulate the revolving door between industry and government for financial regulators, and make the Fed more accountable for systemic financial risk.

While their solution list has merit, let me suggest a simple two-step reform package that I believe would end bubble-bust-cycle: (1) initiate a nominal income targeting rule for monetary policy and (2) adopt macroprudential policies. A nominal income targeting rule would helpful for several reasons. First, it would allow the Fed to see beyond the false comfort of maintaining low inflation. The Fed in in 2003-2005 allowed short-term interest rates to remain inordinately low and economic imbalances to grow because, among other things, inflation was reigned in. Had the Fed been looking at nominal income or spending growth, however, during this time it would been more concerned. (A key problem with an inflation focus for monetary policy is that it only works well with demand shocks. Nominal income targeting , on the other hand, handles both demand and supply shocks. See here for more.) Second, a nominal income targeting rule if strictly followed would help the Fed move away from making bailouts. By stabilizing nominal spending or nominal income, the Fed would minimize the booms, the bust, and thus the need for bailouts. While I believe a nominal income targeting rule would take us a long way in improving both macroeconomic and financial stability, it may not be enough given the political realities outlined above. Consequently, macroprudential regulations such as a countercyclical element to capital requirements would provide a nice complement. Together, these two polices should bring us closer to ending the financial bubble-bust-bailout cycle.

Follow the Leader

Take a look at this figure from the OECD's September 2009 Economic Outlook. It shows the policy rates for the three biggest central banks in the world since 2000. I find it interesting that the ECB and the BoJ appear to follow the Fed's policy rate moves. (Click on figure to enlarge.)


This figure is consistent with the view that the Federal Reserve is a monetary superpower. As I noted before on this issue:
The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).
Put differently, the Fed's monetary superpower status meant it was able to stimulate global nominal spending in the early-t0-mid 2000s. Given there exist nominal rigidities in the global economy, this development meant the Fed temporarily pushed the global economy beyond its natural rate level.