Tuesday, December 15, 2009

Lean Against the Credit Cycle Not Asset Prices

Adam Posen does not think monetary policy should respond to asset price bubbles by adjusting its policy interest rate. He likens this approach to a using a hammer to fix a leaky shower:
[I]f I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit.
Antonio Fatas weighs in and says not so fast; finding that right tool for the job can be elusive so in the meantime we should not shy from using the tools we have--imperfect as they are--in addressing asset price bubbles (hat tip Mark Thoma). All of this attention on asset prices is a distraction says William White in a recent paper. Asset bubbles are but a symptom of a deeper problem, an unleashed credit cycle:
To favor leaning against the credit cycle is not at all the same thing as advocating “targeting” asset prices. Rather, they wish to take action to restrain the whole nexus of imbalances arising from excessively easy credit conditions. The focus should be on the underlying cause rather than one symptom of accumulating problems. Thus, confronted with a combination of rapid increases in monetary and credit aggregates, increases in a wide range of asset prices, and deviations in spending patterns from traditional norms, the suggestion is that policy would tend to be tighter than otherwise.

From this broader perspective, there is no need to choose which asset price to target. It is a combination of developments that should evoke concern. Nor is there a need to calculate with accuracy the fundamental value of individual assets. Rather, it suffices to be able to say that some developments seem significantly out of line with what the fundamentals might seem to suggest. Finally, there is no need to “prick” the bubble and to do harm to the economy in the process. Rather, the intention is simply to tighten policy in a way to restrain the credit cycle on the upside, with a view to mitigating the magnitude of the subsequent downturn...
White address a number of concerns regarding this leaning against the credit cycle approach. This one in particular caught my attention:
As for the more general concerns about undershooting the inflation target, this could lead to outright deflation, but it need not. In any event, it needs to be stressed that the experience of deflation is not always and everywhere a dangerous development (Borio and Filardo, 2004) The experience of the United States in the 1930’s was certainly horrible, but almost as surely unique (Atkeson and Kehoe, 2004). There have been many other historical episodes of deflation, often associated with bursts of productivity increases, in which falling prices were in fact associated with continuing real growth and increases in living standards. As noted above, there can be little doubt that serious problems can arise from the interaction of falling prices and wages and high levels of nominal debt. But the essential point of leaning against the upswing of the credit cycle is to mitigate the buildup of such debt in order to moderate the severity of the subsequent downturn...[emphasis added]
As readers of this blog know, I made this very point in comparing the deflation threat of 2003 with the deflation threat of 2009. Had the Fed been less fearful of the benign deflationary pressures in 2003 they would not have held the federal funds rate so low for so long and, as a result, there would have been less buildup of debt and thus the potential for the harmful form of debt deflation we face today. (In case there are any doubts as to whether the deflationary pressures of 2003 were truly benign see here and here.)

Read the rest of Williams White's article Should Monetary Policy "Lean or Clean" here.


  1. DB:
    More grist for your optimal currency area research program!!

  2. All these interesting papers are starting to take up a lot of my time!

  3. If you were a hot dog vendor, and it was lunch time and everyone wanted a hot dog, would you accommodate them and cook hot dogs? Or would you 'lean against the wind' and reduce your output of hot dogs? If it was 4PM and nobody wanted a hot dog, would you accommodate your customers by cooking fewer hot dogs? Or would you lean against the wind and start cooking hot dogs like crazy?

    A bank is in the business of issuing money, and such a policy is just as bad for banks as for hot dog vendors.

  4. Mike Sproul is raising a good issue (unless I totally misunderstood his hotdog analogy). Money is just the residue of the real business cycle (interpreting real here to be as much about Schumpeter and Minsky as it is about Prescott). Federal Reserve and Taylor rules are shadows on the cave wall - David, Sumner, Woolsey and all the other monetarists are all deceived.

    Even if its not what Mike Sproul meant, I still like the story. Money is endogenous. That is about as incontrovertible a proposition as you can get in macro these days.

  5. ECB:

    You understood correctly. If the economy is booming, there is no reason to snuff the boom with tight money policies. If banks have unwanted piles of cash (as they would during a downturn) there is no harm in the central bank selling assets in order to soak up that unwanted cash.

  6. ECB and Mike:

    Are you saying money is always endogenous? Certainly the money supply is endogenous to some degree, but do you really discount the past 40+ years of empirical research (starting with Friedman and Schwartz)that shows monetary policy matters? How about the the Paul Volker recessions? Do you really believe they were endogenous?

  7. David:

    "Endogenous" is a word I'd rather avoid. An example might clarify. An old-style note-issuing bank gets 100 oz. of silver on deposit and issues 100 paper receipts ('dollars') in exchange, each saying something like "IOU 1 oz.".

    Then a farmer asks the bank for a loan of 200 paper dollars, and offers his farm (worth at least 200 oz.) as collateral. The bank would happily issue another $200 in paper, in exchange for the farmer's IOU, which has a present value of 200 oz.

    The bank has just tripled the supply of paper dollars, but each paper dollar is still worth 1 oz. of silver, since the bank has 300 oz. worth of assets backing the $300 it issued.

    You could say that the extra $200 was issued endogenously, since it was only created because the farmer wanted it, but it's more important to say that the extra $200 was adequately backed by the farmer's 200 oz. IOU, and so would not cause inflation.

    It would be a mistake for the issuing bank to lean against the wind. The $200 was only issued because the farmer wanted it badly enough to hand over his 200 oz. IOU, and if the bank refused to issue it, that would stifle economic activity for no reason.

  8. What I had in mind was the notion that bubbles and financial crises have been around ever since the dawn of the industrial revolution and appear impervious to the nature of the monetary regime, be it gold standard, or fiat standard.
    They seem to be a fundamental aspect of organizing the division of labor under the capitalist rules of the game. They represent a crucial aspect of the process of creative destruction to be very Schumpeterian about it.
    Financial innovation is part of that capitalist process. For example, hire purchase was a key innovation in the 1920s and played a role in the credit boom of that era by encouraging consumer purchases of big ticket items like automobiles. Similarly, we had the securitization innovation in the 1990s.
    In times of euphoria, when the possibilities of new technologies appear limitless (after all, we just lived through the 1990s IT boom, we know how intoxicating these times can be) it may take a very large increase in interest rates to snuff out a perceived large increase in the MEC - and as Mike Sproul asks, would you want to? Might you not be impairing the capitalist growth dynamic ?