Noland: Don’t Get Hopeful About Fed Interest in Asset Bubbles

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There has been a raft of articles about the Federal Reserve’s new found interest in the question of asset bubbles, suggesting that the Fed might be ready to shift policy and exhibit more willingness to rein them in. Yesterday, a page one Wall Street Journal story discussed at length research central bank chairman Bernanke has sponsored at Princeton, and noted:

The Fed is giving the activist approach some thought. In a speech scheduled for delivery Thursday night, Fed Governor Frederic Mishkin suggested that while it was inappropriate to use the blunt instrument of interest-rate increases to prick bubbles, if too-easy credit appeared to be fueling a mania, policy makers might craft a regulatory response that could “help reduce the magnitude of the bubble.”

Doug Noland at Prudent Bear takes issue with the view that the Fed might be changing its approach and gives a close reading of the Mishkin speech:

The conclusions from Professor Mishkin’s paper differ only subtly from previous doctrine:

First, not all asset price bubbles are alike. Asset price bubbles that are associated with credit booms present particular challenges….Second, monetary policy should not try to prick possible asset price bubbles…Instead, monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability… Third, because asset price bubbles can arise from market failures that lead to credit booms, regulation can help prevent feedback loops between asset price bubbles and credit provision. Our regulatory framework should be structured to address failures in information or market incentives that contribute to credit-driven bubbles.

Mishkin suggests regulatory remedies might help prevent unhealthy booms, but even the ideas he presents as possible solutions are minimal. Information failures? The research described in the Journal article essentially said that investors get overly excited about a broad scale innovation and start bidding up prices of related investment opportunities beyond realistic levels. Those with more cautious views step aside, unwilling to get killed, until the bulls exhaust themselves. Pray what information failure can you point to in that? The negative information is out there, just as it was during the housing bubble. But it was ignored. Mishkin is pointing to instrument-specific misunderstandings, as with investors buying MBS and CDOs, they really didn’t understand. But what information failure was there in the dot-com era? It was clear to all that the vast majority of companies had no realistic prospect of turning a profit, yet ownership of “eyeballs” became the new version of tulip mania.

Back to Noland:

I’ll posit this evening that the entire issue of “central bankers vs. asset Bubbles” has become little more than A Red Herring. While it is as of yet too early in the unfolding financial and economic crisis for “consensus opinion” to have reached a similar conclusion, in reality contemporary monetary management can already be proclaimed an unmitigated failure. Cloaked in ideology and a flawed conceptual framework, the Greenspan/Bernanke Fed sat idly by as history’s greatest Credit inflation and myriad resulting Bubbles irreparably damaged the underlying structure of the U.S. Credit system and real economy (before going global). And while the Fed executes its latest round of post-asset Bubble “mop up,” precarious Credit Bubble dynamics are left to run similar roughshod through global financial and economic systems. Better to downplay the asset Bubble issue for now, as we contemplate the nature of what will be a much altered post-Global Credit approach to central banking.

From Mishkin:

The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.

In no way do I believe “the ultimate purpose of a central bank” is to “foster economic prosperity,” and I certainly don’t expect any such grandiose mandates to survive in the post-Bubble environment. On many levels the notion that central bank policies are instrumental in creating prosperous economic conditions is problematic. For one, it grossly over promises in regard to the long-term benefits derived from government manipulation of interest-rates. Secondly, it virtually guarantees an accommodative policy regime and, inevitably, a strong inflationist bias. Thirdly, such a nebulous objective invites overly discretionary policymaking, along with an activist and experimental approach to monetary management. Fourthly, such an approach ensures that policymaking errors beget greater and compounding errors.

Noland is correct to point to the dangers of continued Fed mission creep. Noland again returns to quoting Miskin:

From Mishkin:

After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative. …If monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small. More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.

This passage, in particular, goes right to the heart of several key failings of current doctrine…The problem with post-asset Bubble “accommodation” is that it specifically accommodates the very Credit infrastructure and related Monetary Processes that financed the preceding boom. It works to validate the present course of financial innovation (think “Wall Street securitizations,” “CDOs” and “carry trades”), while emboldening those at the cutting edge of risk-taking (think “leveraged speculating community”)…..

Moreover, a commitment to aggressively cut rates in response to faltering asset Bubbles openly courts leveraged bond market speculation – a market dynamic that engenders artificially low market yields and exacerbates liquidity excess during the late-stage of asset bubbles (think bond market “conundrum”). The last thing a central bank should encourage is an entire industry dedicated to placing leveraged bets on the direction of Federal Reserve policy responses…

The overriding flaw in the Greenspan/Bernanke approach has been to openly disregard Credit Bubble dynamics, in particular the increasingly profound role being played by Wall Street-backed finance in fueling Credit, market liquidity and speculative excesses. I believe The Ultimate Objective of a Central Bank is to Foster Monetary Stability in the broadest sense. In this regard, asset Bubbles should be viewed primarily as important indicators of some type of underlying Monetary Disorder. The key analytical focus must be on the underlying Credit and speculative dynamics fueling the asset price distortions – to better understand and rectify the source of “disorder” – and the earlier, the better.

The most dangerous policy approach is to further incentivize a system that has already demonstrated a proclivity for Credit and speculative excess – employment, output and “deflation” concerns notwithstanding….

Greenspan, Bernanke, Mishkin and others repeatedly stress the inability of policymakers to recognize the existence of a Bubble until after it pops. It is my view that the entire notion of asset prices dictating monetary policy is flawed. The focus should instead be on the underlying sources of monetary fuel – the Credit growth and financial flows underpinning asset inflation and economic boom….

Central bankers can and should avoid being in the difficult position of having to respond directly to inflating asset markets. Instead, there must be carefully fashioned, communicated and administered “rules of the game”. To begin with, it is incumbent upon the Fed to clearly articulate to the public (and their elected officials) the overwhelming benefits of stable Credit and financial conditions. It must be conveyed that Credit and speculative excesses are destabilizing, fostering boom and bust dynamics and structural impairment. The public must come to appreciate that the effects of destabilizing Credit inflation come in many forms, including asset price inflation and Bubbles, Current Account Deficits, currency debasement, traditional consumer price inflation, and various distortions to underlying Financial and Economic Structures.

Volcker could carry this off, as possibly could have earlier former non-academic Fed chairmen (ie, not Arthur Burns). But it seems the Fed has been badly, hopelessly captured by the industry, which is the converse of what is desirable. Unless a new President is able to find and slowly restock the Fed with men and women with some good old fashioned probity, the instability and propensity to financial excess will only get worse.

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  1. Anonymous

    “We make the rules – the news, war, peace, famine, upheaval, the cost of a paper clip… you’re not naive enough to think we’re living in a democracy are you? It’s the free market.”
    Gordon Gekko

  2. Richard Kline

    I am in complete agreement with Doug Noland’s assessment here. The Fed’s accomodative bias to boom bubbles and open the spigot on the bust side is deeply entrenched. The markets know they have a capitve balloon and have adapted accordingly. This Hasn’t Gone Well, and Miskhikin’s summary reads far more as an apologia and continued endorsement for this failed approach than any call for change. Yes, Miskkin acknowledges indirectly that the credit bubble this time got way out of hand and, maybe sorta, similar _credit_ algae blooms should be managed better in the future. But, quoth he, the Fed should continue to intervene to keed the Financiers’ Enrichment Scheme operational at all times [my summary].

    The financial system cannot be managed by interest rate dodgeball games alone. Noland points the way that financial flows within the system must be monitored and constrained if we or anyone is serious about avoiding bubbles in the future. This is an issue presently much on my mind as well.

    Furthermore, the stated policy that the Federal Reserve System has a policy charge of ‘responding to unemployment’ is the worst kind of hokum. It does nothing of the sort. It is anathema to many in the US that we have an interventionary _government exectutive_ which acts to ameliorate unemployment with benefits and retraining while intervening directly in the economy to stimulate employment through spending, subsidy, partnerships, and the like. Why, “that’s Socialism.” So the Congress and the Exectutive especially want, need, and loovvvve to have their hands tied when it comes to acting against unemployment. “That’s the Fed’s brief.” And what does the Fed _do_? It makes money cheap and easy at the top of the financial system in hopes that financiers will make so much money some of it trickles down into the real economy. What this means is that, in the guise of alleviating unemployment the Fed bails out bankers to keep them happy, profitable, and lending.

    The appropriate role of a central bank is to keep the financial system from killing itself, which said systems have a demonstrated propensity to do. A central bank needs to look to the currency it manages as well, but this also requires coordination with the public fisc, something which has badly broken down in the US as well. The more a central bank commits itself to enhancing bankers’ prosperity, the more bad policy we will see.

    I agree with Noland also, however, that ‘it is early yet.’ We haven’t hit the worst parts of this trough at all so far. So there is time and more to publicize the severe costs of bubbles to accumulated capital and consumer-level financial health and planning. Bubbles are bad, whether in asset prices, credit, or malinvestment; they DO NOT equate to real growth. Many get rich on the the way up; but many more lose much on the way down. One would think that central bankers would understand this, but clearly the ones we have now do not: They can be replaced. We need central bankers committed to financial system stability, and a govenrnment committed to real productive investment rather than speculative wealth gains. The more we talk about the issue while the consequences of failue are before the eyes of all, the more likely we are to achieve change.

  3. bobo7874

    It is well and good to try to spot bubbles, but at least equally important are regulatory restrictions on the too big to fail financial instititions. I like Martin Hutchinson’s idea of making too big to fail institions have strict regulatory capital requirements, preventing them from investing in a class of instruments with more than 10% of the assets on their balance sheet unless their regulator is confident they are sound, and preventing them from investing in small financial institutions not subject to these rules (merchant banks).

    As well as allowing the merchant banks to invest in anything, so long as their assets/obligations do not grow big enough to push them into the too big to fail category, and if they are given access to any fed subsidies, maintain certain capital requirements.

    This is a link to Hutchinson’s article

  4. Max

    Interesting – it’s not OK to use the blunt tool of FFR to prick asset bubbles, but it is _just fine_ to use the same blunt tool to prop them up.

  5. Anonymous

    Very well said. In eight short years, the US has gone from a balanced, robust wealth to near bankruptcy.

    Wall street feeds on borrowing capacity and leverage. The day the Fed and the treasury became de facto members of the board of Citicorp is the day the bubbles began. It is difficult to overstate the malfeasance here.

    There were many opportunities to end the fraud. The Bushco team used the courts to deflect attempts by the States to address the issue. The question is not just about bubble creating and sustaining Fed policy but also about opposing a rogue government dead set on destroying the wealth of the average American. Fear of opposing the rogue government plays a bigger part than is generally recognized.

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