Monday, July 13, 2009

What if the Federal Reserve Had Listened to the BIS?

What do you get when the key insights of Hyman Minsky--prolonged macroeconomic stability can actually be destabilizing if it causes observers to take for granted the "good times" and underestimate risk going forward--and Frederick Hayek--price stability is not a sufficient condition for macroeconomic stability--are accepted by a group of mainstream economists? You get economists who were able to foresee as early as 2003 the current economic crisis and issue a warning. And just who are these economists? They are the research staff at the Bank for International Settlements (BIS), formerly led by William White. Der Spiegel has a great article on William White and his colleagues that highlights how they repeatedly warned central bankers of the dangers lurking ahead but to no avail. What is amazing, is that the BIS is the bank for central banks and had the ear of Alan Greenspan and other central bankers. In other words, these were not a bunch of economic cranks, but serious research economists at a top economic institution who were given a hearing but ignored by top policymakers. Here is Der Spiegel:
[William] White and his team of experts observed the real estate bubble developing in the United States. They criticized the increasingly impenetrable securitization business, vehemently pointed out the perils of risky loans and provided evidence of the lack of credibility of the rating agencies. In their view, the reason for the lack of restraint in the financial markets was that there was simply too much cheap money available on the market. To give all this money somewhere to go, investment bankers invented new financial products that were increasingly sophisticated, imaginative -- and hazardous.

As far back as 2003, White implored central bankers to rethink their strategies... The prevailing model [at central banks] was banal: no inflation, no problem. But White wanted central bankers to take things a step further by preventing the development of bubbles and taking corrective action. He believed that interest rates ought to be raised in good times, even when there is no risk of inflation. This, he argued, counteracts bubbles and makes it possible to lower interest rates in bad times. He also advised the banks to beef up their reserves during a recovery so that they would be in a position to lend money in a downturn.
William White and his crew took this message directly to key players time and time again. Among other publications, they did so with this paper presented at the Fed's Monetary Policy symposium at Jackson Hole Wyoming in August 2003 (Greenspan was in attendance), as well with this paper titled "Is Price Stability Enough" in 2006, and in many of the popular BIS Annual Reports. My favorite article of the bunch is the second one above which happens to have been written by White himself. Here are some excerpts:
It will be argued in this paper...that achieving near-term price stability might sometimes not be sufficient to avoid serious macroeconomic downturns in the medium term. Moreover, recognising that all deflations are not alike, the active use of monetary policy to avoid the threat of deflation could even have longer term costs that might be higher than the presumed benefits. The core of the problem is that persistently easy monetary conditions can lead to the cumulative build-up over time of significant deviations from historical norms – whether in terms of debt levels, saving ratios, asset prices or other indicators of “imbalances”. The historical record indicates that mean reversion is a common outcome, with associated and negative implications for future aggregate demand.


One implication of positive supply side shocks is that they call into question whether monetary policy should continue to pursue the near-term [monetary policy] target of a low positive inflation rate... Failure to adjust the [monetary policy] target downward (whether explicitly or implicitly) in the face of positive supply shocks would result in lower policy rates than would otherwise be the case... Paradoxically, taking out insurance against a benign deflation might over an extended period increase the probability of the process eventually culminating in a “bad” or even “ugly” one.
This is the same point I have made here on this blog: by avoiding the benign deflationary pressures of 2003 the Fed help put in motion the developments that created the malign deflationary pressures of 2009. If only the folks at the BIS had been taken more seriously. One can only imagine how different the current economic crisis would have been.

Update: Presto Pundit in the comments points us to an article that chronicles the ongoing debate between William White and Alan Greenspan.


  1. As you note, those who predicted the crisis came from the non-mainstreamers, such as Austrians and post-Keynesians, suggesting they have a superior framework for understanding macro issues. (But we can of course bet that 99% of US macro instructors will still be using Bernanke and Mankiw's textbooks this fall !! )
    You may be interested in this article which discusses the threads common to the successful forecasters.

  2. In an interview a month or two back, White says that he pulled Greenspan aside, one-on-one in 2003 at Jackson Hole, and point blank told Greenspan what what happening and that he needed to change course.

    Greenspan rejected the idea.

    I posted on this story at my "Taking Hayek Seriously" blog.