Summer Rerun: The Fed: The Need for a Paradigm Shift

This post first appeared on May 1, 2007

Due to Paul Volcker’s having broken the back of inflation in the early 1980s, and Alan Greenspan performing what appears to be adequately on the substance of his job and masterfully at the showmanship, the Fed’s reputation is at an all time high. And that in and of itself is a danger sign.

The Fed’s difficulty is that it has worked very successfully within established paradigms for the last 20 years. But these paradigms appear to be working less well than in the past both in explaining economic outcomes and in suggesting policy measures. But an institution with the stature of the Fed can’t be seen to be at a loss, or worse, experimenting (even though its inflation targeting is pretty much improvisation and guesswork).

My layman’s view is that the Fed is focused on what are now viewed as its traditional issues: inflation and growth, and of course its regulatory function, assuring the soundness and stability of the banking system (although that activity, while still important, is vastly less powerful as banks are playing a smaller and smaller role as credit providers relative to securities markets participants).

These issues, while important, are on the periphery of where the danger lies. The real risk is to the stability of the financial system, while its role is defined more in terms of assuring the safety and soundness of particular institutions (the safety of the whole derives from the safety of the parts).

Admittedly I know very little about the inner workings of the Fed. But very successful commercial enterprises generally aren’t very good at adapting to significant environmental change. Oh, they are typically brilliant at adapting within a familiar range of variance. But go beyond their comfort zone, and they respond worse than a less competent organization, because that sort is often better at making things up as they go along. And that syndrome is more acute the more an organization dominates its environment.

In fairness, the Fed has done a lot to try to extend its mandate to deal with these new concerns. It has tried to understand (but not intervene in) the risk management practices of major financial players. And it forced a bailout of LTCM, a failed hedge fund, even though it had no jurisdiction over many of the key creditors (investment banks).

Where I fault the Fed isn’t in trying to do the best it can within its regulatory confines; it has actually been pretty creative in extending its reach. But it has failed in encouraging thought, investigation, and debate about our Brave New World of finance. For example, a recent paper in Risk Magazine discusses how credit risks are more linked than most observers believe, which means systemic risk is also greater. Yet the Fed staunchly defends the opposite view: that risks are better diversified than ever.

Consider, as another example of old paradigm thinking, this article in the Guardian, “A deer in the headlights,” by James Galbraith (also cited at Mark Thoma’s Economist’s View). It discusses, more pointedly and colorfully than most, the policy dilemma that the Fed faces. In an economy with slowing growth and a still-active risk of inflation, either cutting or raising rates looks to be a wrong move. Like the myth of Scylla and Charybdis, it seems impossible to navigate between the shoals without falling victim to either monster. So the Fed does nothing, which Galbraith argues is a mistake (he believes “globalization killed inflation years ago” and therefore the right course is to cut rates):

According to normal practice, when inflation jumps the Fed should tighten, and when growth stumbles it should ease. Hello rock. Hello hard place. What is a central banker to do?

The most likely answer is, freeze. [Fed Governor Ric] Mishkin’s speech prefigures this. He carefully acknowledged every known aspect of the slowdown so far. But he still projects that the economy will, nevertheless, continue to expand at a “moderate and sustainable” pace. This projection, and not current facts, governs the policy stance. So long as the Fed does not change forecasts, no policy changes are required. Deviations below the forecast – such as just occurred – are simply evidence that the future will be stronger, not weaker, than the recent past. Policy should therefore not respond. Thus, the deer in the headlights.

I believe the real problem is completely different. We are framing the problem incorrectly. The interest rate/monetary policy crowd is focusing on nominal inflation and ignoring asset bubbles and systemically low risk spreads. It’s one thing when a sector gets overheated and pricing and credit terms get out of line. It’s another when the phenomenon is so widespread.

But because the Fed and mainstream economists don’t have a good theoretical framework for thinking about this set of issues, they soldier down familiar paths and hope that things will somehow work out (when in doubt, put your faith in the invisible hand). And this state of imbalances has persisted so long that it’s easy to be complacent about them. And if you are the Fed, the last thing you want to do is sound a false alarm and create panic.

Another central banker, Ian MacFarlane, the recently retired head of Australia’s Reserve Bank, is particularly concerned that policy makers are working within a framework suited to yesterday’s, not today’s problems. (By weird happenstance, the last time I invoked MacFarlane was after another Mishkin speech). Yet disappointingly, his comments haven’t gotten much play in the Northern Hemisphere:

Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy. This has acquitted itself well over the past 15 years and is still working effectively, but over the next decade or two will probably face the type of challenges I have outlined.

No one is very good at picking the next major epoch, and we mainly react after the damage has been done. I am influenced by the fact that as the great inflation of the 1970s was building from the mid-1960s, no one, including the central bank, had a mandate to prevent it. As we struggled to come to grips with it, governments made decisions that effectively gave the central bank a mandate, and central banks worked out a framework that to date has been effective in dealing with it. No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.

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One comment

  1. marc fleury

    The pendulum of regulation/deregulation has swung too far to the deregulated end.

    The FED should be praised for its handling of the monetary crunch… after all that is the main reason we got off the gold system, so that we do not end up constrained by something as silly as the amount of yellow metal in our economies. This crisis, as all true crisis of insolvency, started with a serious liquidity crunch. Markets evaporated, cash preference kicked in strongly. Maintaining liquidity in this context is what a modern fiat money system do, in a MMT way. A crisis of insolvency can not be solved by the FED, a crisis of liquidity can. Solving a crisis of insolvency in the presence of a crisis of liquidity triggers fisher instability much faster, due to the rapid breakdown of markets. I think this current crisis will prove that dealing with insolvency while having liquidity softens the blow.

    Finally, the FED could not regulate what it couldn’t see. The shadow banking system was feeding off OTCs. After all when 2007 hit, the naked CDS instruments spread the risk by demanding cash on a volume of 7-8 times the bad debt. These should have been banned. These volumes came out of the shadow when they blew up and required public purse backing. Those volumes need to be recaptured by regulation.

    The main problem the FED was facing, imho, is that regulation is enacted using the accounting tools of the past crisis: balance sheet accounting. That, by definition, failed to capture off-balance sheet instruments. The latest financial bill introduces public exchanges for the derivatives. This is a necessary first step to regulation. You can not regulate what you cannot measure. The definition of “liquidity” also needs to expand to take into account the near-money instruments spun by the banking system. Many of the bond derivatives are in fact near-money instruments, or instruments that become money at the worst possible time.

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