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Mishkin Defend Bubbles (and of Course, the Fed)

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The press becomes more surreal with every passing day. If we didn’t all have a stake in the outcomes, this would make for great theater.

First we have the absurd spectacle of bankers claiming that they are doing God’s work. Great! Then they should be willing to do it for free. I don’t recall the Bible discussing Jesus getting eight or nine figure compensation (or what passed for it back then), and the Gautama Buddha, born a prince, gave up all the trappings of wealth.

Now for those who follow the markets, we have the Ministry of Truth in action on the comment pages of the Financial Times, in the form of today’s offering, “Not all bubbles present a risk to the economy,” by Frederic Mishkin. Somehow, that headline strikes me as trying to make the case, “Nuclear wars don’t have to be bad for you.”

In other words, this appears to be yet another instance of Team Obama attempting policy by PR rather than (novel idea!) actually crafting sensible programs and sticking to them. The Fed has been operating fist in glove with the Treasury throughout the crisis; the idea that it is independent is a joke. The Fed is clearly involved in a concerted program to reflate distressed assets (most notably housing) that has spilled into just about every type of investment (and a few that have not traditionally been investments, namely commodities).

The Fed had been trying to argue that asset prices were irrationally depressed (funny how they had no problem with market prices when many fund managers saw they were wildly elevated, when risk spreads were absurdly low, and there was abundant evidence of froth in the credit markets). Now plenty of central bankers outside the US have been worrying out loud about the bubble in progress (they are framing it officially as a future problem, but reading between the lines, it isn’t hard to infer that they are concerned that it is already under way). And what has the Treasury and Fed said? Nothing beyond pointing out that they have tools for mopping up excessive liquidity.

So now we have former Fed governor Mishkin, curiously stepping up now to defend the officialdom. I was told by a well-connected reader after the bloggerfest at Treasury that Team Obama was in full court press mode, trying to curry goodwill with others to burnish the perception of its financial policies. It isn’t hard to imagine that Mishkin was asked to assist.

It was Mishkin who in January 2007, argued that:

that this concern about burst bubbles may be overstated. To begin with, the bursting of asset price bubbles often does not lead to financial instability…Japan’s experience is that the serious mistake for a central bank that is confronting a bubble is not failing to stop it but rather failing to respond fast enough after it has burst….

With a track record like that, should anyone take anything he says about bubbles seriously?

Mishkin also argued:

one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets…

Yves here. We have the counterexample of Ian MacFarlane, governor of the Reserve Bank of Australia, who set out to combat Australia’s housing bubble. He did so by beating up on the banks, frequently pointing out that housing prices had risen too far, too fast and probably did not represent a great investment, plus a couple of judicious rate hikes. Australia is generally credited with having done a much better job of contending with its housing bubble than any other country in the same fix.

By definition, a bubble is a massive price distortion in certain types of assets. That is already not a good thing. If you believe in markets, you believe in the value of price mechanisms because they lead to efficient allocation of goods and services and help channel investment funds to productive uses. At a minimum, bubbles are bad because they suck capital into seriously suboptimal uses at the expense of better ones. So ANY defense of bubbles has to be regarded with considerable skepticism. Bubbles are bad even when they fall short of the standard of wrecking an economy, which appears to be the base line Mishkin is using in his FT piece. He contends that bubbles that are not fueled by credit are not really that pernicious:

The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

Yves here. While narrowly true, this is all a bit slippery. The Fed was worried enough about the dot-com bust to drop rates WELL below the level indicated by its usual approach, the Taylor Rule, and held them there for an exceptionally long time. If this was such a benign bust, why did the Fed engineer and maintain negative real yields for so long?

The 1987 crash is a peculiar case. Even though equities had risen to bubble territory, the crash was worse than it should have been thanks to program trading. Moreover, Mishkin bizarrely omits that there WAS a credit component, namely LBO lending, which had been at high levels prior to the crash, picked up again in 1988 and was at high levels in 1989. The LBO bubble did help fuel the equity price rise (I recall a report in 1987 attributing 75% of the appreciation that year to takeover speculation, and a proposed measure to tax highly levered transactions was one of the proximate causes of the crash, see the Brady Report for details) but that did not unwind till the end of 1989. For some reason, the banking crisis of 1990-1991 is always depicted as an S&L crisis when non-S&Ls (including GE Capital) were big holders of really horrid takeover loans and took significant balance sheet hits.

And the commodities runup of the first half of 2008 would fit in Mishkin’s typology of “not so bad” bubbles. Jim Hamilton thinks, by contrast, that the rise in oil prices was the detonator for the credit contraction, that higher gas prices pushed overstretched consumers over the brink. And the agricultural commodities price spike led to riots over high soyabean and grain prices.

But Mishkin reverts to the same arguments he used in January 2007:

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.

Yves here. This is pure and simple willful blindness. And his argument, that policymakers are incapable of recognizing bubbles is silly. Investors and speculators (crudely speaking) have tougher stomachs than analysts (and presumably policy makers). You need to be willing to take losses and many people are not wired to do that. Being able and wiling to play in markets every day takes certain personal attributes that go beyond analytical ability. Bubbles are extreme events, they are less difficult to recognize than day-to-day investment picks.

Moreover, Mishkin offers a straw man: that the only way to stanch an asset bubble in a particular market is via monetary policy, which is a blunt instrument. Now it is true that the only tool readily available to the Fed now is monetary policy. But the Fed was lobbying to act as macroprudential regulator. It seems very peculiar that, in this post-bubble carnage, it has not done much of anything to generate thought (staff papers, for a starter) on the issue of what tools in addition to monetary policy authorities need to have at hand to be able to attack bubbles in specific, but significant, markets. For starters, you can restrict leverage, put limits on types of trading that might favor purely speculative momentum traders, etc (you’d need to look into particular mechanism peculiar to the relevant markets to devise a surgical intervention).

Mishkin’s arguments are absurd, except they reflect the Fed’s complete unwillingness to take on this task. It is much easier to offer the excuse that you are incapable (and talk yourself into it), than deal with the bigger issue: that pricking an asset bubble is unpopular. As Macfarlane noted:

Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….

Yves again. What is truly disconcerting about Mishkin’s remarks is that, even though he is no longer at the Fed, they probably represent conventional wisdom there. And that means the officialdom has gained perilous little insight from this disaster. George Santayana warned about the consequences of failing to learn from history….

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41 comments

  1. NYT

    From Zerohedge:

    Fed director Fred Mishkin will suffice, who in May 2006 penned a report titled “Financial Stability In Iceland.”

    Some pearls of wisdom from Mishkin’s extensive understanding of the (soon to be bankrupt) Icelandic economy:

    Fiscal imbalances are not a problem in Iceland: quite the opposite, with Iceland having an excellent fiscal position with low government net debt (less that 10% of GDP) and a fully funded pension system (with assets amounting to more than 120% of GDP).
    Monetary policy has also been successful in keeping inflation low and near the inflation target, particularly when housing prices are excluded from the inflation measure, as is the case in the United States and the eurozone.
    Research on multiple equilibria suggests that self-fulfilling prophecies are unlikely to occur when fundamentals are strong, as they are in Iceland.
    The analysis in our study suggests that although Iceland’s economy does have some imbalances that will eventually be reversed, financial fragility is currently not a problem, and the likelihood of a financial meltdown is low.
    Iceland is an advanced country with high-quality institutions. GDP per capita (adjusted for PPP) ranks fifth highest in the world; longevity is the highest for females and second highest for males; unemployment is almost non-existent and way below the natural rate; net government debt is almost nil, labor force participation among older workers the highest in the world, and of women the highest in the OECD (almost 80%, compared with 56% on average in the OECD).
    Noteworthy among Iceland’s country rankings for quality of institutions is that Iceland ranks fifth in economic freedom, firs in terms of the lowest corruption, seventh in terms of competitiveness, first in the percentage of population connected to the Internet (ADSL or ISDN), and the first in terms of
    freedom of the press, compared with number 113 for Turkey and 59 for Thailand [and 666th for America].
    And of course:

    These rankings are of course sometimes arbitrary, but they clearly illustrate that Iceland is a well run, advanced Nordic country that has little in common with emerging market countries, a fact important to recognize when we start discussing financial stability in the next section.

  2. fresno dan

    “…than deal with the bigger issue: that pricking an asset bubble is unpopular.”
    Ask the average person to name a Fed chairman prior to Greenspan, and I doubt 1 in a thousand could do it. In the ninties there was a cult of the Fed – and it was due to one reason – ever lower interest rates and bailouts (LTCM, Mexico, etcetera).
    At the most fundamental basis, the people running the economy believe that prosperity is based on ever more finacial legerdermain. Borrowing is not income, debt is not wealth.

  3. Albatross

    Yves,

    Was Mishkin also not super confident about Iceland before the country almost bankrupted?

    Gee, these Fed mouth puppets are always at work regardless how wrong they have been, aren’t they?

  4. enrique

    Lets make it more simple : If the Fed and other Central Banks operate according to a quantitative measure concernign the “right” level of inflation ( for example “Less but close to 2%” in EU) ,or the “proper” salary increae ( supposedly the “cause” for inflationary pressures) then they should be able to develpop a tool which can identify deviations from a proper level of assets prices . We have recently seen that asset inflation poses significant risks to the whole economy ( as CPI inflation does).
    The lack of interest in such a tool is another demonstration of the asymmetric role of the FED and other CB in the economy .

  5. Skippy

    Wow the propaganda/marketing//animal spirit herding must be all they have left. All economic theory’s of their liking expended, others discounted on idealogical reasons, unpalatable. This is not a good sign when the Tokyo Rose types of wall st are blasted across all of MSM, bringing the good news to all of main st.

    Skippy…Thanks for the video Yves, I had to jump to Slims big ride first although. Just a thought Peter S. would have done a nice Timmy G. soft shoe at the Fed boardroom lavatory when interrupted by Nancey P. coming out of the elevator ha ha priceless.

  6. killben

    Glad he is a Former Fed Governor …

    The list of clowns is endless .. with the specky buffoon being the best of them …

    Pity Ron Paul’s bill will not do what its aim was .. Audit the Fed .. and then Kill it ..

    Do you want to be led by such clowns .. I wonder…

  7. attempter

    Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.

    This is a standard forensic trick among scoundrels. You see it everywhere. They take their preferred status quo, which is itself an aggressive, often radical policy (in this case, easy money), and represent it as the absolute, natural, rational, moderate baseline from which everything else has to be judged.

    So any proposed change, even toward what in true absolute terms would really be toward moderation, toward some reasonable center, is represented as the radical departure.

    “Do no harm” is demanded, while the often vast harm being done by the radical status quo is zeroed out.

    Look around, you see this kind of argument everywhere.

    The MSM generally abets them in this.

  8. john

    Once again I am reading about economists trying to justify their actions by comparing themselves to physicians.

    I am so tired of hearing how the economy was in the “ICU” or the Fed had to perform “emergency surgery” and use “potent medicine”. And now we have Mishkin pulling out the Hippocratic Oath. Please, just because your field has been exposed as a complete fraud do not attempt to elevate it by comparing it to modern medicine. First we had with physics envy and now we have medicine envy.

    Mishkin, just come clean and admit your field is pseudoscience. Report back in a decade or so when you clean house and throw out all the ridiculous assumptions on which your field is based.

  9. Graphite

    It is much easier to offer the excuse that you are incapable (and talk yourself into it), than deal with the bigger issue: that pricking an asset bubble is unpopular.

    Indeed, it is precisely the unpopularity of pricking bubbles that will probably prevent central banks from *ever* conducting sane monetary policy in an environment of widespread speculative fervor. They are subject to the political and financial climate as much as anyone, as the Fed’s total loss of independence demonstrates.

    Lombard Street notwithstanding, this is a fundamental weakness in the notion of central banking as such. You’d better make damn sure you have apolitical superbeings administering your central bank, or all it will do is concentrate and amplify the risks of a mania-driven credit expansion.

  10. Graphite

    Or, as James Grant puts it much more succinctly, “are human beings competent to administer a system of fiat currency backed by nothing?”

  11. NotTimothyGeithner

    Although his words were about abortion, I think the President’s statement of his support for the status quo for abortion explains his economic policy. The President just wants to please everyone, keep things the way they are, and act like a celebrity.

  12. constantnormal

    ALL bubbles are joined at the hip via leverage, and could not exist without leverage. Leverage always involves debt in some form or other, as the working medium by which the “leverage” is obtained.

    If Mishkin cannot see the “pure irrational exuberance” of the equities boom in the late 1920s and follow it through to the credit collapse and the Great Depression, then he is a fool indeed.

    All bubbles are creatures of debt leverage, and all bubble impact the credit markets when they implode. The only differences are the size of the bubbles and the strength of the credit markets at the time of collapse.

  13. Siggy

    Mr Miskin must be retarded; or perhaps he is on the take as a shill for the oligarchy that is the federal Reserve. It might also be that he has an abiding need to justify what has become the greatest financial market failure of two centuries. One has to wonder about the editor of FT. Under what reasoning would they publish such absolute shit think?

  14. Trademark

    it is disgusting really.

    Hey this type of bubble is not as bad as that sort of bubble… so its not a big deal. So the “asset bubble” of housing wasn’t that bad?

  15. Hugh

    Mishkin’s comments have really nothing to do with bubbles and almost everything to do with the defense of the elite to which he belongs.

  16. i on the ball patriot

    Bubble Exhaust Analyzer

    The bubble exhaust analyzer,
    Reveals the bubbles popping story,
    The controlling elite are always richer,
    The masses always poorer and gory,

    The exhaust also shows a pattern,
    Of ever present and guileful deception,
    Always hidden by sell out scribes,
    That prevents the masses perception …

    FT — Tool Of The Man

    Deception is the strongest political force on the planet.

  17. Colin Suttie

    Who claims Australia has dealt with it’s housing bubble better? Here in Melbourne, the average house now sells for about 8 times average income, and houses regularly sell at well-attended auctions, to desparate buyers, for $100k or more over the guide price. We’ve handled it as well as Canada, which is to say we’ve simply kicked the can up the road & locked in a bigger crash later.

    1. ozajh

      But with prices re-accelerating upwards again there comes a point where I can’t help wondering whether “they” can kick the can down the road forever.

      I’ve been waiting for the crash since I sold in 2004 at what I thought was the top of the market (in Canberra). The buyer would make about $250K profit if he sold today . . .

  18. max

    The Fed has been operating fist in glove with the Treasury throughout the crisis; the idea that it is independent is a joke.

    Well, honestly, it strikes that the Fed is running Treasury, not the other way around. The Fed, for all practical purposes, achieved the status of independent governing entity during Greenspan’s tenure, only very slightly responsive to democratic control.

    Moreover, Mishkin bizarrely omits that there WAS a credit component, namely LBO lending, which had been at high levels prior to the crash, picked up again in 1988 and was at high levels in 1989.

    It strikes me that essentially, in 1987, the bubble had built to height wherein it was easily ‘naturally’ collapsed. So it did. Greenspan’s move to save the stock market, essentially perpetuated the bubble, which went on for another two years until fraud, waste and abuse (as they always term *government* not corporate spending) ate everything and Greenspan could not save the banks from their folly. The recession that followed was hard on everyone but the financial markets, which was just fine with Alan. And in fact, the ’87 collapse was an excellent reason, apparently, for the Fed and the banks to lobby for less regulation of finance.

    1998 was a similar situation. Had LTCM collapsed normally, the markets almost certainly would have gone in reverse, whereupon Greenspan would’ve dropped the interest rate to zero until the thing collapsed from fraud, waste and abuse, and consequent loss of savings on the part of millions of middle-class people. Which the bubble eventually did anyways, because ginourmous society-wide Ponzi schemes are simply not economically tenable without whole lot of um, socialist intervention (SHHH! Don’t call it that!) in the ‘free’ markets. In support of rich people.

    It seems very peculiar that, in this post-bubble carnage, it has not done much of anything to generate thought (staff papers, for a starter) on the issue of what tools in addition to monetary policy authorities need to have at hand to be able to attack bubbles in specific, but significant, markets.

    Again, it strikes me that the people at the Fed, UChicago and other such places are not anti-bubble in any way. They’d like to keep the bubble going (the big 20 Year Bubble) as long as possible, because, well, it’s been so good for them. They just have to force the government to intervene on their behalf to protect them, (complete with inflation… of the market) and this is working. For them. Forget the Principle-Agent Problem at banks, let’s talk the Principle-Agent Problem at the Fed.

    Obviously, people like Summers and the like don’t think this scam can go on forever, but the alternative as far as they are concerned is worse. So they’ll keep inventing Scotch tape and bailing wire solutions to get themselves through the crisis, and lie about what they’re doing the whole way. That’s why they keep saying they going to fix this problem with tough regulations that never actually appear. That this is bad for America in the long run… well, that, they no doubt view themselves AS America. Too bad for you useless eaters.

    Conservatives used to be fond of saying that countries collapse once the proles learn they can vote themselves bread and circuses. It so turns out that the proles are not the problem, except as suckers to be conned – the rich have been voting themselves bread and circuses. Nothing will change in Versailles and at Marie Antoinette’s peasant playhouse absent a revolution or collapse of the system. And since they have no interest in changing things before that happens, then automatically, it will happen.

    max
    ['There really doesn't seem much difference in the lifestyles of the rich and famous between France, Russia (twice!) and even Nazi Germany. The leaders acted like idiots until they were forced out or killed. And here we are.']

  19. Ed

    If you look closely, you can sort of see a rational argument here. For cultural reasons, people priced houses for far less than they were worth until this decade, and equities for far less than they were worth until last decade. The economies of the 50s and 60s weren’t particularly healthy because finance, insurance, and real estate made up too little a component of wealth.

    Now, if you believe this, you are insane. But this seems to be what our decision makers believe. Otherwise their attempts at policymaking make no sense.

  20. i on the ball patriot

    The ultimate bubble …

    The god bubble that the banker’s are now selling is actually a very effective bubble. In essence what they are saying to the faithful is, “Believe and accept that my greater wealth here in the now is approved by god and you will get your profit when you die.”.

    By coat tailing religion in this fashion they avoid bank examiners, government regulators, controlling legal BS, etc. And of course when those who invest in the god bubble die there is no profit to pay out.

    Talk about leverage — sheesh!!!

    Do you believe in the god bubble?

    Deception is the strongest political force on the planet.

    1. mad professor

      an undernoticed quote from Lord Blankenstein:

      “I’ve got news for you,” he shoots back, eyes narrowing. “If the financial system goes down, our business is going down and, trust me, yours and everyone else’s is going down, too.”

      how’s that for some Old Testament wrath?

      1. psychohistorian

        The existing system needs to crash so a fairer and more sharing/less greedy one can rise from the ashes.

        1. Skippy

          Looks likes an Atkins protein diet supplied by W&K St feedlots, just need to rustle up some greens.

          Skippy…health care solution right here folks!

  21. Victor

    Yves, as usual I agree with just about everything you say, however the last quote from Mishkin reveals a very deep truth that we all need to understand. Please read it again, carefully:

    “If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….”

    This is, literally, the handwriting on the wall for our financial system, if not capitalism itself. It represents a very deep truth, probably much more so than Mishkin intended, the truth that there is absolutely no way to regulate our present financial system.

    Capitalism is a train that cannot be halted once it reaches a certain velocity, because the consequences of putting on the brakes would be as devastating as the inevitable crash at the end of the line. Except that the brake catastrophe would come first — and the person who applied the brakes would get ALL the blame.

    There is NO course the government can take that will prevent catastrophe. If they tried to apply the brakes, even by the slightest amount, the train would fly off the rails and THEY would be blamed. Our economy has for too many years depended on paper profits “earned” by dubious banking maneuvers and if we took steps to control that out of control system, it would simply collapse, because it’s principal source of income would be too seriously diminished.

    No one wants to hear this, but the only sane solution would be to wait for the next crisis, let it happen, let the system totally collapse of its own weight, and then have the government pick up the pieces by nationalizing everything in sight, take full control of the economy and rationing available resources. The losses would be purely paper losses, the biggest losers would be the billionaires, but the labor force and the resources needed to sustain it would still be there.

  22. Vinny G.

    “Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”

    Right. Like that ever stopped any doctor from doing what he or she wanted to do anyway. I have a better idea: how about putting a few hundred of of these bankers in prison for long periods of time (to be read as “life without parole”) and confiscating all their money. If they refuse to surrender the cash, a little waterboarding will likely make them more cooperative.

    Harsh, but just :)

    Vinny

  23. farang

    I would have to label this comment the “Ivory Snow” winner for today: 99.44/100% pure(ly correct.)

    Died holding my breath for the masses to see it.

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