Fed Taken to the Woodshed at Davos

A panel of blue chip authorities, including former Treasury Secretary Larry Summers, legendary investor George Soros, and well respected economists such as Stephen Roach and Nouriel Roubini were sharply critical of the stewardship of central banks in recent years, particularly the Fed.

We’ve noted before that not all central bankers were asleep at the switch. Australia’s retired Reserve Bank Governor Ian Macfarlane used a combination of private scolding, public statements, and a wee interest rate tightening to let some air out of the lucky country’s housing bubble, which by every measure was worse than our own. Macfarlane has also spoken and written about the problems that asset bubbles present to monetary authorities (big issue: they are popular while in progress and central banks lack a clear mandate to tackle them). But why has Macfalane been virtually alone among the officialdom in talking about this problem, and why hasn’t his message gotten greater play?

From Bloomberg:

The U.S. Federal Reserve and other central banks are partly to blame for the financial-market slump that’s now threatening to derail the global economy, said investors and former policy makers at the World Economic Forum.

“It’s hard to give central banks a very high grade over the last couple of years on recognition of bubbles and actions taken to address them in the policy or regulatory spheres,” said former U.S. Treasury Secretary Lawrence Summers in a panel in Davos, Switzerland. Billionaire investor George Soros said central banks have “lost control” of financial markets.

The Fed, which yesterday announced its first emergency rate cut since 2001 as U.S. recession fears rose, has been criticized for paying too much attention to economic growth and not enough to so-called asset price bubbles. By cutting rates to protect growth when bubbles burst, the Fed only encourages investors to take bigger risks in the future, said Morgan Stanley’s Stephen Roach.

“It’s a dangerous, reckless and irresponsible way to run the world’s largest economy,” said Roach, chairman of Morgan Stanley in Asia, who was also in Davos…..

“Central banks lost control of the situation when they allowed financial institutions to develop new financial instruments which they themselves didn’t understand,” said Soros.

Greenspan and Bernanke counter that it’s too difficult for central banks to spot bubbles before they emerge and raising rates to curb higher housing or stock prices would risk derailing the rest of the economy.

Nor was the Fed alone in slashing rates at the start of the decade. The ECB cut its benchmark to 2 percent in 2003, the lowest since the aftermath of World War II, and the Bank of England reduced its key rate to a 48-year low.

While house prices surged in the U.K., Spain and Ireland, those booms have now withered as contagion from the subprime collapse spreads.

Some Davos attendees came to the Fed’s defense, saying it’s difficult to identify bubbles and more attention should be paid to better regulation.

“We could pierce bubbles but we’d pierce a lot of non- bubbles and take a lot out of gross domestic product,” said John Snow, also a former Treasury Secretary and now chairman of Cerberus Capital Management LP. “We need to reform regulation.”

The ECB nevertheless argues that it may be possible for central banks to “lean against the wind” by raising rates in the early stage of a bubble to head off future gains.

“It’s good for a central bank to ease when the risks are of a crash in the global economy, but that means you have to have a more systematic approach to asset bubbles,” said Nouriel Roubini, founder of New York-based Roubini Global Economics LLC, in Davos. “If we have a `Greenspan put’ or a `Bernanke put,’ then we will create over and over again a distortion of excessive debt and leverage.”

Print Friendly, PDF & Email


  1. Anonymous

    Some regions of the U.S. housing market are showing signs of unsustainable “speculation” and “froth” based on fast turnover of existing homes, Federal Reserve Chairman Alan Greenspan said. The price surge may “simmer down” as housing becomes less affordable, he said.

    “It’s pretty clear that it’s an unsustainable underlying pattern,” Greenspan said in response to a question after a speech on markets to the New York Economic Club. “People are reaching to be able to pay the prices to be able to move into a home.”

    “There are a few things that suggest, at a minimum, there’s a little froth in this market,” Greenspan said. While “we don’t perceive that there is a national bubble,” he said that “it’s hard not to see that there are a lot of local bubbles.”

  2. Anonymous

    The easiest way for central banks to tackle asset bubbles would be to make it clear that they are prepared to tolerate some deflation. And why shouldn’t they? If there is to be general price stability then it is obvious that some years of inflation have to be balanced by some years of deflation. And if it can be said that central banks have a responsibility to maintain the money supply, then deflation is the best tool in their arsenal to achieve that since deflation automatically increases the real money supply. But the articulation of these points by central bankers would be pointless unless politicians and politcal appointees, e.g. Treasury Secretaries, back them up. And politicians are unlikely to back up these ideas unless they have penetrated the mainstream idea workers, i.e. journalists and the commentariate. And these ideas will not penetrate the commentariate unless they are taught by the professors. So whenever a society really gets into trouble, the first place to look for its source is the university.

  3. Yves Smith

    Anon of 11:31,

    Agreed, The fear of deflation is overdone. The US had mild deflation for most of the 19th century.

    The Depression and Japan has led everyone to believe that deflation = liquidity trap. But in the case of the US, the reason that interest rate cut weren’t stimulate wasn’t that you couldn’t cut below zero. The much bigger problem was that banks were failing and no one with an operating brain cell would put his money in a bank.

    In Japan, the issue was that the banks were so full of bad loans that they effectively had negative equity. Again, the problem wasn’t primarily monetary. Monetary policy is not going to fix bank insolvency, which is what you had in both cases.

    In fact, my impression is that deflation (now) in Japan is understated. That means you have no nominal growth but real growth. Similarly, that means a .5% nominal rate could be a 2-3% real rate. That’s better than you get here on money funds.

    It is to the Japanese advantage to perpetuate the image that they are a basket case, now that they have finally cleaned up their banking system, so we don’t bust their chops over their massive trade surpluses.

    The orthodoxy is that the best policy is mild inflation, 2% ish.

Comments are closed.