Richard Alford: Fed Hasn’t Learned From the Crisis

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

Even prior to the financial crisis of 2007, economists and policymakers actively debated whether central banks should use interest rate policy to “lean” against possible asset price bubbles or “clean” up after an asset price bubble burst, reserving interest rate policy for inflation targeting. A consensus has started to emerge: there are instances in which it would be advantageous for central banks to use interest rate policy to lean against asset price bubbles. Some current and former Fed officials have reversed their position and now embrace the consensus view. This view is consistent with the position that the Fed kept the Fed funds rate “too low for too long,” but any admission of that by Fed officials remains implicit at best. It also appears that the Fed has not generalized any lessons it might have learned from the crisis. It has committed itself to both exceptionally low interest rates for an extended period of time and now to QE despite parallels between run up to the crisis of 2007 and current developments in the currency and international capital markets.

Speeches by Vice Chair Yellen and former Vice Chair Kohn and recent testimony by Bernanke reflect this somewhat reluctant acceptance of the idea that in some cases leaning against price bubbles is appropriate policy.


It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system.

By the same token, I would not want to argue that it is never appropriate for monetary policy to take into account its potential effect on financial stability. Regulation is imperfect. Financial imbalances may emerge even if we strengthen macroprudential oversight and control.


We should not categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause; the FOMC is closely monitoring financial conditions for signs of such imbalances and will continue to do so.


For all these reasons, my strong preference would be to use regulation and supervision to strengthen the financial system and lean against developing problems. Given our current state of knowledge, monetary policy would be used only if imbalances were building and regulatory policies were either unavailable or had been shown to be ineffective.

All of the statements, as reluctant as they are, indicate a clear retreat from the position that interest rate policy should never reflect concerns about financial stability. The position that interest rates were too low for too long is most clearly reflected in the Kohn statement. Kohn lists two contingencies, which if both are met, warrant the Fed setting rates higher than inflation and the output would imply. They are 1) economic/financial imbalances must exist, and 2) regulatory policies must be absence or ineffective. (I would add that the imbalances must reflect unusually rapid credit growth.) Both of the contingencies were clearly satisfied in the period post-2001. There were numerous unsustainable economic and financial imbalances: the personal savings rate near zero, and an economy reliant on unsustainable levels of consumption and housing investment relative to income, both of which were driven by unsustainable asset prices. In addition, major financial institutions were over-leveraged and reliant on short-term funding. As we all know, regulatory policy was ineffective or nonexistent.

At the risk of putting words in Kohn’s mouth, he clearly suggests that interest rates were too low given the imbalances and the state of regulation. It is not a full confession, but perhaps a mea culpa.

Unfortunately, the Fed seems unable to generalize from the lesson that at times appropriate interest rate policy is a function of more than just inflation and the output gap. Currently, the large, unsustainable global financial and economic imbalances are parallels to the imbalances that existed in the US prior to the crisis. The international organizations charged with promoting and maintaining stability in the international markets are woefully inadequate to deal with a crisis involving the Dollar.

Nonetheless, the Fed seems bent on setting policy as if US prices and income were exclusively determined by domestic economic concerns and despite its status as the bank of issue of the world’s reserve currency. Bernanke’s recent speech made no mention whatsoever of any non-domestic policy concerns. Despite unsettled currency markets and the US’s status as a capital importer, the Fed has embraced QE and pledged to pursue a low interest rate policy for an extended period of time, presumably regardless of any international developments.

It is fair to say that the Fed is once again demonstrating its decided limitations as a risk manager. Given the current economic climate and recent developments (FX intervention and introduction of capital controls), the a risk of a Dollar crisis is much more than tail risk. The costs given a crisis are difficult to estimate as a Dollar crisis would be a currency crisis wherein the currency in crisis had been the reserve currency. Range and pattern of diffusion are anybody’s guess.

If a risk management discipline were applied to the decision to adopt QE, it would rule out the Fed’s position as stated by Bernanke. The costs to the US (and the world) economy that would be experienced should Fed policy precipitate a Dollar crisis would be much larger by orders of magnitude than any probable (or possible) benefits that might be realized if QE is able to raise inflationary expectations. In his recent speech, Bernanke alluded to a risk return analysis of QE, but he just seems to have ignored the existence of the rest of the world and any feedback on the US.

Print Friendly, PDF & Email


  1. attempter

    Even prior to the financial crisis of 2007, economists and policymakers actively debated whether central banks should use interest rate policy to “lean” against possible asset price bubbles or “clean” up after an asset price bubble burst, reserving interest rate policy for inflation targeting.

    I subscribe to the theory that someone who consistently does the same thing over and over really wants and intends to do exactly that thing, no matter what he claims to want.

    Since the Fed consistently engages in pro-bubble monetary policy, and looks set to embark upon QE2, I think we need to induce that giving the zombie banks sufficient liquidity to blow up bubbles is precisely, consciously what the Fed wants and intends to do.

    1. DownSouth

      The attribution of policies—-in the manner of Milton Friedman, for instance—-to “intellectual” confusion, George Stigler suggests, is “singularly obfuscatory.” When a government policy has been in place for a long time, the only proper conclusion is that it serves the interests of the governing class.

      Even though Stigler was a great admirer of Smith, he criticizes even Smith’s policy views on these grounds:

      I wish to recur for a moment to the policy of mercantilism, which Smith attributed to the clever machinations of the merchants and traders against the simple, honorable landowners who still constituted the government class of Great Britain in his time. Smith and his followers should have asked themselves whether simple error could persist, to the large and centuries-long cost of a class intelligent enough to hire the likes of Edmumd Burke. I say, with great fear and trembling, that it is more probable that Smith, not the nobility of England, was mistaken as to the cost and benefits of the mercantile system.

      If the behavior of regulators is seen to be rational in any sense (as a good Chicago economist must assume it to be), Stigler believed it will be rational only in serving the rational needs of the regulator. It will consist of nothing more than individuals “agitating for their own amusement or private advantage,” such as earning higher consulting incomes and appearance fees for speeches.

      Thus existed a serious intellectual disagreement between Stigler and Friedman. Stigler once wrote that Friedman, along with Frank Knight and Hayek, subscribed to “mistake” theories which held that “the actors in political life are ignorant, emotional, and usually irrational.”

      But Stigler challenged the “mistake” theorists. As Robert H. Nelson writes in Economics as Religion:

      Yet as Stigler realized, any assumption of widespread error in decision making was uncongenial to the Chicago school of economics. Another long-standing part of the Chicago tradition—-one reason that it believes markets work so well—-is an assumption of full rationality in individual behavior. Consumers, for example, understand their own preferences exactly, know price options precisely, and respond perfectly to maximize their individual welfare….If people can see their way to behave so rationally in the marketplace, might similar rationality perhaps characterize behavior in the political arena as well? Perhaps there as well they can see the available tradeoffs precisely, and make political deals carefully calculated to maximize their welfare.

      attempter, don’t get me wrong. I don’t agree with Stigler’s pessimistic take on humankind. But Stigler is far more intellectually honest, and his arguments not nearly so riddled with cognitive dissonance, as Friedman, who was never anything more than an instrument of Wall Street (though a very effective one).

      1. DownSouth


        Let me rephrase that.

        I don’t agree with Stigler’s pessimistic take that human’s always act with their own self-interest in mind. I believe humans to be entirely capable of being able to make sacrifices for a greater good, or to put it another way, they are capable of acting morally.

        I also don’t believe that humans always act rationally.

        However, these characteristics, like all human behavioral traits, exist on a continuum and not in discreet categories. Some people are highly rational and others highly irrational, with most being somewhere in between. Likewise, some people are highly moral and others highly immoral, with most being somewhere in between.

        I do believe, however, that the governing class in America today is made up of people who are both highly rational and highly immoral.

        1. Siggy

          I agree. As legally constituted the Fed is the agent of the banking system that exists by charter, State and Federal, at the pleasure of the government, State and Federal.

          Since 1913 we have had continuous inflation. QE and QE2 are inflation. The Full Employment Act of 1946 was predicated on the Keynesian concept of government invention and the preferred instrument of intervention has been easy money in terms of rate and availability: i.e., inflation.

          It’s not that the Fed and the Treasury are the least bit stupid or naive. It’s that inflation is seen to be a very poltically safe way to generate economic expansion. Thus, inflation becomes the rising tide that will lift all boats. It matters not that the boats suffer serious leaks and will end up at the bottom of an overflowing ocean of money.

          To some extent, Bernanke is correct to fear a great deflation. But then, one must recognize that we have had a great inflation, especially from 1971 forward. What is more than passing strange is that with our great inflation we have not had an equitably distributed increase in wages and wealth. The great benefits of our great inflation have accrued to the top tier earners, or are they really thieves.

          It’s not that the fed hasn’t learned, it’s that the public has not apprehended that the singular source of the economic duress at hand is that the public has allowed the Congress and the Financial Services industry to control the currency and the financial markets to the point of eschewing the prosecution of blatant fraud.

          To the extent that the Fed proceeds with QE2, we shall all be made proportionately poorer and substantially closer to a global monetary collapse.

        2. attempter

          I agree regarding the continuum and where this ruling class lies upon it. (Although by “rational” I’d agree only on instrumental rationality, using otherwise rational tactics of continuing to rob the passengers even as the runaway train’s about to jump the tracks. I don’t mean the kind of rationality which would say, “let’s get control of the train first.”)

          So Freidman and the Chicago Boys reversed reality exactly, claiming the layman “market participant” is always rational, but that it’s precisely those with the most information and education and power to act who are as children? That does not surprise me.

  2. Doc at the Radar Station

    Excellent posting. This reminds me of some recent posts by others:
    “Asset inflation, price inflation, and the great moderation”
    …and Michael Pettis’s
    Some conclusions to draw IMO: We need to get trade and capital flows balanced, so that we can have reasonably ‘normal’ interest rate policies without deflation, excessive unemployment, and asset bubbles.

    1. micr line

      how can you balance trade when half the planet is run by corrupt regimes who imprison anyone fighting for higher pay or better working conditions.

  3. Random Blowhard

    The Fed will never raise interest rates, infinite free money is the only thing keeping the TBTF zombies even pretend solvent. A currency crisis ala Greece or, god help us, Iceland will be the only way interest rates increase above ZIRP within the next 50 years.

    1. jwlato

      I agree. I fail to see any circumstance short of complete revolution whereby the Fed meaningfully raises the rate within the next two decades at least.

  4. Jackrabbit

    While QE2 could be a significant help to the banks (especially TBTF banks), its effect as an economic stimulus is diffuse (indirect, second order) and, likely to be insufficient (due to a cost/benefit constraint). Although the Fed has stated that they will move cautiously, analysts fret that QE2 will spark inflation and significant dollar devaluation. Yet, it seem to me that the Fed has just enough room for just enough QE2 that the banks could get a significant benefit without incurring much negative effect (the costs/benefit constraint). Thus, QE2 appears to be JABB (Just Another Back-door Bailout), and the more that we take QE2 seriously as a measure to help the economy, the more “cover” such an unpopular policy action is provided. Furthermore, to the extent that it takes pressure off Congress to act responsibly, any amount of QE2 has a detrimental effect because it delays effective (fiscal) action.

    In addition, one can reasonably wonder about the effect of QE2 enthusiasm on the upcoming debate over extending the Bush tax cuts. It is likely that those who favor extending the Bush tax cuts, whether temporarily or permanently, will have a better case to make. If the government were to lose the added revenue from an increase in taxes on the wealthiest, the government’s ability to provide future fiscal stimulus (if, as seems likely, QE2 is not sufficient) will be undermined.

  5. craazyman

    I don’t think one can speak completely of QE2 (or QE1) without including Wall Street’s plan to loot the economy again with a projected $144 billion in 2010 bonuses.

    If there was a forceful national political and institutional recognition that Wall Street firms, Banks, all of them, are dead-men-walking without a U.S. Government/Federal Reserve ZIRP Rescue and that executives AT ANY LEVEL and IN ANY POSITION don’t deserve pay over $500,000 TOTAL COMP and that they’re still lucky to even have a job. Period.

    (And, really, $500G isn’t a Che Guevera-style limit) I can cook anything with three pots — a frying pan, a soup pot and a spaghetti boiler. I have prepared very fancy meals with these items, and a toaster oven. Who needs a Chef’s Kitchen? Nobody, really. It’s an out of control addiction to compensate for soul loss. But that’s another post . . .

    Then there wouldn’t be the outrage. Debate, sure. But outrage. Not likely, in my view. It would be more a polite but barbed intellectual debate that pitted the Viagrans against the Austerians and the monetarists against the fiscal I-want-to-pump-you-ups! ending in an American-style pragmatic “We’ve got to try it ’cause it might work” sort of thing.

    Now if that $144 billion were deposited in community-based banks and multiplied 10 to 1 through lending that is $1.4 trillion in potential stimulus. That’s about 10% of GDP.

    10% of GDP!!!!

    So where will the real QE2 go? First into bankster bonuses and then into their brokerage portfolios and then into emerging market economies, into commodities, into Gold, into Strip clubs, into Rolex watches, into complex option strategies, into . . . . nowhere that will do any good at all for most Americans and potentially a lot of bad.

      1. craazyman

        Amen. I don’t even go anymore. But for the younger guys, it’s a rough hit on the wallet. :)

        Better to go get a “massagie” and don’t waste your money on a lap dance. ha ha ha. even that, though, it makes me soul sick now that I can see the skies. But what is youth for.

        1. Cedric Regula

          Ya. I don’t go to ones in the US anymore ever since I heard that’s where the unemployed bankers and loan brokers got jobs. At least the ones that can pole dance.

          But speaking of productivity gains, the strip clubs just south of the border are worth an occasional visit.

  6. Jimbo

    A question for those against QE2. Given that Congress hasn’t acted, and probably won’t during the next two years, especially if the GOP emerges with a 20 to 30 seat majority in the House, what do you suggest we do to address these imbalances? If not fiscal policy, what?

    1. Jackrabbit

      It seems to me that the Fed is not saying that they are acting against “imbalances” (which to me mean trade and capital flow). They have said that they feel compelled to help but want to be careful about how they proceed so as to not do more harm than good.

      Also, with China pegging its currency to the dollar and many nations threatening competitive devaluation, too much dollar devaluation doesn’t necessarily result in a more competitive trade position.

      Anyway, given what the Fed is saying, I think people are assuming too much. The Fed seems to be willing to use whatever wiggle room it has, but I think that will not be nearly enough and will be more helpful to the banks than the unemployed. From the Fed’s perspective, support for both (banks and economy) are good things but QE2 is being sold as help for the economy, not the banks (for obvious reasons).

      As far as Congress goes, QE2 provides a convenient excuse not to act. But I suppose Congress will act when it has to.

      1. Jackrabbit

        Oh, and I’m not so much against QE2 as I am FOR a clear understanding of what QE2 does and what it can do.

        1) A lot of people are not aware of the great deal of indirect support that have been provided to the banks.

        2) By selling QE2 as help for the economy (only) QE2 gives Congress a convenient excuse to not act. It also gives ammunition to those who want to see the Bush tax cuts extended.

  7. gs_runsthiscountry

    So, others at the Fed are now having a “Greenspan Epiphany”, a “eureka moment” as it were. Well ain’t that just dandy.

    Too bad it is, “A day late and devalued dollar short.”

  8. Hal Horvath

    Perhaps it’s already been pointed out, but the idea in the post that the current QE parallels the “un up to the crisis of 2007” is fundamentally incorrect. It’s much like saying that because the previous call to the fire station (2002 concern about deflation) was a false alarm, that therefore the fire station should not respond to any more calls. It’s a basic error.

    To understand the real relation between the actions of the Fed and the global economy, read instead Martin Wolf and even Ambrose Pritchard

Comments are closed.