Sunday, August 24, 2008

Willem the Bold

That is my new name for Willem Buiter who boldly challenged the Federal Reserve and its policies at one of its own meetings. Buiter presented a paper that was very critical of the Fed's actions leading up to, during, and after the housing boom-bust cycle at the Fed's annual Jackson Hole, Wyoming retreat. The Wall Street Journal and Bloomberg both report his paper generated a heated debate at the meeting. Coming to Buiter's rescue in the blogosphere is Yves Smith while Mark Thoma sides with the Fed. I have only scanned his paper (144 pages!) , but here is a section from it that summarizes his critique of the Fed:
I argue that three factors contribute to Fed’s underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.

The second is a sextet of technical and analytical errors: (1) misapplication of the
‘Precautionary Principle’; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on ‘core’ inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.


The third cause of the Fed’s macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.
Yves Smith says points 1 and 3 are valid, but 2 is debatable. It will be interesting to see what other observers say on these points. On a different note, I found interesting his suggesting for addressing asset bubbles:
Therefore, while I agree with the traditional Greenspan-Bernanke view that the official policy rate not be used to target asset market bubbles, or even to lean against the wind of asset booms, I do not agree that the best that can be done is for the authorities to clean up the mess after the bubble bursts...[Rather,] [c]ountercyclical variations in capital and liquidity requirements [or] an automatic financial stabiliser [is needed.]
This is something to consider, but I submit that a nominal income targeting rule would go far in avoiding the formation of asset bubbles in the first place. But I digress. This is a provocative paper that should fuel debate for some time to come.

1 comment:

  1. Who are those high speed computing economists running the Kalman filter model of the economy?

    Take their Kalman model, and actually measure the yield curve of the economy. (Power Spectrum of the main diagonal) Use that as the basis of the interest rate curve, hiking rates above the actual yield enough to cover the costs and make a profit.

    Or, simply deregulate the monetary system, allowing anyone to distribute USA dollars, as long as they keep their monetary bonds in the active market