Friday, August 14, 2009

Fed Smackdown Edition

My critiques of Fed policies in the early-to-mid 2000s are beginning to look tame compared to these observers. First, here is a Free Exchange summary of a Lutz Kilian paper:
[E]xcessively accommodative monetary policy and regulatory policy over the last decade may have led to unsustainably high global growth, which in turn was responsible for a demand driven spike in oil prices. There are two angles to this. One is that the natural unemployment rate was higher than the Fed thought, and the only way to push unemployment below that level was to facilitate bubbles in the financial and housing sectors, which excessively juiced demand and enabled the oil spike. The other is that lax monetary policy kept American consumption at too-high levels, leading to very rapid emerging market growth (which was exacerbated by the fact that dollar pegs led to importation of loose American monetary policy in trading partner economies).

Boiling this down, Mr Kilian seems to be suggesting that a monetary policymaker with this reading of the economy would have acted more cautiously than someone with Ben Bernanke's view ("that the oil price shocks of the 1970s and 1980s arose exogenously with respect to global macroeconomic conditions"), potentially reducing the magnitude and impact of the 2007-2008 oil shock.
Next up is Daniel Gross, Jacopo Carmassi, and Stefano Micossi. They write in this Vox article that too many observers confuse the symptoms of the economic imbalances as causes. For example, they note the following:
A key feature of a speculative bubble is the attendant anomalous convergence of expectations that occurs when a growing share of investors believes that prices can only go up and that the risk of reversal somehow disappears... Shiller believes that convergence of expectations is a natural, endogenous phenomenon engendered by such things as a long-established benevolent economic environment and economic innovations announcing a new era of prosperity...

However, a straightforward alternative is that monetary policy itself provided the anchor for the convergence of expectations, based on the consistent record that any decline in asset prices would be countered by the Federal Reserve with vigorous monetary expansion. Indeed, Alan Greenspan had just arrived at the Federal Reserve at the time of the 1987 stock market crash; he promptly reacted by aggressively lowering policy interest rates. He did it again in 1998 at the time of the LTCM crisis that followed the East Asian and Russian crisis, and even more aggressively after the end of the bubble in 2000. In all these episodes, there were no adverse effects of falling asset prices on economic activity and subsequently stock prices recovered.

The pattern is clear – the Fed repeatedly and systematically intervened to counter “negative bubbles”, while it remained passive when confronted with accelerating credit and asset prices. This policy approach, long established and clearly announced for over a decade, must have played an important role in bringing about convergent expectations of ever-rising asset prices, which eventually destabilised financial markets and the economy. Such an asymmetric monetary policy creates a gigantic moral hazard problem, whereby all agents expect to be rescued from their mistakes.
They conclude,
... the massive financial instability of 2007-8 was primarily the result of lax monetary policy, mainly in the US. The regulatory system compounded this error by tolerating excessive leverage and maturity transformation by banks in the US and Europe. Innovation did contribute to credit expansion and instability, but in all likelihood, without lax money and excessive leverage, reckless bets on asset price increases would have been much reduced.
Finally, Simon Johnson calls on the Fed for an apology for its failure to even consider financial sector issues in its 2003 FOMC meetings:
[T]his and other FOMC transcripts make it clear that the senior Fed decision makers [in 2003] were not even thinking about the first order financial sector issues. They weren’t aware of what the big investment banks were really doing – show me the intelligence reports before the FOMC or the analytical discussion that indicated any degree of worry. No doubt someone somewhere in the Federal Reserve system was thinking critically about finance – feel free to send me any relevant details - but from the point of view of evaluating the institution, it only counts if the top decision-making body at least has the issues on the table.


I fully understand that financial market considerations are not the established focus of central bank interest rate deliberations. But the scope and nature of such deliberations has changed a great deal since the founding of the Fed almost 100 years ago. As the economy changes, central banks have to adapt their conceptual frameworks and our broader regulatory frameworks need to change also.

Huge problems were missed by people using anachronistic conceptual frameworks. Those frameworks should change... Our top monetary policy makers completely missed the true nature of the Great Bubble and its consequences, until it was far too late. They should apologize for that and we can start work on redesigning the institution, its decision-making, and how financial markets operate, to make sure it won’t happen again.
That is enough Fed smakckdown for one day.

1 comment:

  1. You left out the best smackdown of all though!!
    Of course, today's economic Phds disdain any hint of morality (how do you take its first derivative for heavens sakes!!) but the founding father did write Theory of Moral Sentiments....