This post first appeared on August 24, 2008
Go Willem Buiter! The London School of Economics prof and former Bank of England and European Bank for Reconstruction and Development official has been saying for some time that the Fed suffers from “cognitive regulatory capture” and has been far too responsive to the needs of Wall Street. It’s been puzzling to watch his detailed, well argued criticisms go unnoticed, particularly when they have been offered at forums where one would think they’d be impossible to ignore (for instance, a conference co-hosted by the New York Fed where Buiter presented a pretty harsh paper on what he called the North Atlantic Financial Crisis).
Well, he finally seems to have gotten through, perhaps because he is forward enough to criticize Fed officials to their face at an event they are hosting. Or maybe it’s because the pattern of conduct he decries is so patently obvious that the key actors can no longer fool themselves. From Bloomberg:
Former Bank of England policy maker Willem Buiter sparked the biggest debate at the Federal Reserve’s annual mountainside symposium, saying the central bank pays too much heed to the concerns of financial institutions.
“The Fed listens to Wall Street and believes what it hears,” Buiter said yesterday in a paper presented to the Fed’s conference in Jackson Hole, Wyoming. “This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous.”
Mr. Buiter slams the Federal Reserve, European Central Bank and Bank of England for what he says was a mishandling of the financial crisis and monetary policy over the past year. He gives the worst marks to the Fed, saying it’s too close to Wall Street and financial markets — responding to their needs to the detriment of the wider economy. Mr. Buiter, a former member of the BOE’s Monetary Policy Committee, said the Fed overreacted to the economic slowdown — misjudging the importance of financial stability to the overall economy — and created a deeper inflation problem as a result.
The paper is quite long, but it is very well written and moves very quickly for this sort of exercise (it does get geeky from time to time). I will confess to having read only the first 30 pages, but his argument seems spot on:
My thesis is that both monetary theory and the practice of central banking have failed to keep up with key developments in the financial systems of advanced market economies, and that as a result of this, many central banks were to varying degrees ill-prepared for the financial crisis that erupted on August 9, 2007.
The Fed gets disproportionate attention, in part due to the venue of the presentation, in part because Buiter contends that the Fed did the worst job of the major central banks. Note that Buiter is more of inflation hawk than we are, but as a result, Buiter thinks that letting housing prices decline is not the end of the world and implicitly, adjustments need to run their course (per his point 4). Even though we think this deleveraging will be nastier than Buiter anticipates, we think that trying to hold asset prices at inflated levels will inevitably fail and the effort will only create more damage. To Buiter again:
[T]hree factors contribute to Fed’s underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.
The second is a sextet of technical and analytical errors: (1) misapplication of the ‘Precautionary Principle’; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on ‘core’ inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom
that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.
All three central banks have been too eager to blame repeated and persistent upwards inflation surprises on ‘external factors beyond their control’, specifically food, fuel and other commodity prices. The third cause of the Fed’s macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.
Of his three charges, Buiter is on solid ground on the first and third. The second set (his points 1-6) are debatable, but you can make a case for them, and he does.
Some of his comments are blunt:
In the case of the Fed, the nature of the arrangements for pricing illiquid collateral offered by primary dealers invites abuse….
All three central banks have gone well beyond the provision of emergency liquidity to solvent but temporarily illiquid banks. All three have allowed themselves to be used as quasifiscal agents of the state, providing subsidies to banks and other highly leveraged institutions, and assisting in their recapitalisation, while keeping the resulting contingent exposure off the budget and balance sheet of the fiscal authorities. Such subservience to the fiscal authorities undermines the independence of the central banks even in the area of monetary policy.
There is a lot of good stuff. For instance, Buiter discusses the “asymmetric” response of regulators to asset bubbles (they let the bubble run but jump in to try to arrest the collapse) and discusses remedies.
Unfortunately, a lot of participants seemed more interested in defending the Fed than in sifting through Buiter’s analysis to see what might be valid and useful:
Fed Governor Frederic Mishkin said Buiter’s paper fired “a lot of unguided missiles,” and former Vice Chairman Alan Blinder “respectfully disagreed” with his analysis of the central bank’s crisis management…..
Mishkin lashed out against Buiter’s assertion that the Fed’s rate reductions may cause higher consumer prices.
“I wish he had actually read some of the literature on optimal monetary policy, because it might have been very helpful in this context,” said Mishkin, who collaborated with Bernanke on inflation research in the 1990s.
Mishkin, a leading advocate of the Fed’s effort to sustain economic growth through rapid rate reductions, said research shows that “what you need to do is act more aggressively.”
In reply, Buiter said the value of such a strategy “is not at all obvious to me.”
[Bank of Isreal’s Stanley] Fischer, drawing laughter from the audience, held up a red fire extinguisher saying, “I asked the organizers for some technical assistance in dealing with this discussion.”
While defending the Fed, Blinder said Buiter’s papers “often feature an alluring mix of brilliant insight and outrageous statements.” The central bank’s performance, though not flawless, has been “pretty good” given the magnitude of the crisis, he said.
European Central Bank President Jean-Claude Trichet also came to the Fed’s defense, saying “what has been done until now has been pretty well done under very difficult circumstances.”
Although the Wall Street Journal coverage of the response is less detailed, it says that Blinder, who was tasked with critiquing the paper, told a long-form version of the Dutch boy putting his finger in the dam, and said that Buiter would rather have the dam leak out of obedience to his belief in moral hazard, and let the dam burst.
I may be reading too much into this, but it strikes me that Blinder went out of his way to be insulting (anyone who regularly participates in critiques of academic papers please read the WSJ post and comment).
Part of the problem is stylistic. Even though Buiter is Dutch by descent and dislikes the idea of national identity, his writing style often echos the cut and thrust of Parliamentary debates, a posture that is also well received in English academe and drawing rooms but not well received in the US. So his bluntness is over-the-top by US standards.
From this vantage point, it’s obvious that the Fed has become far too dependent on current Wall Street incumbents and thus can be manipulated by them (and in fairness, the people who are doing the persuading may be completely sincere in their views). There were ways to compensate: cultivate contacts with former executives who no longer have close ties, find independent analysts who have useful data and perspectives. No doubt Fed officials have extensive contacts, but it appears they have not been used in a deliberate, orchestrated fashion to test and validate information provided by those currently employed by major financial firms.
The second issue is that even if the Fed is too close to the financial services industry, it still may have made the right policy decisions. The jury is still out. Many people (probably including the Fed officials) hope the crisis has passed, while readers of this blog know there is good reason to think the worst has not arrived in earnest.
Buiter has taken a bold position, The Fed needs to be able to explain why what is good for Wall Street is also good for the economy as a whole. The sort of questions that Buiter is raising are notably absent from the media and US-based first rank economists. The Bloomberg story may not give a full enough account to be certain, but the responses to Buiter’s charges do not seem persuasive. They amount to disputes over analytical methods and assertions that everything is working fine (after providing a $400 billion fix with no withdrawal plan and getting support from foreign investors equivalent to $1000 a person. So what’s your next act?).
It will take some time to see if events prove Buiter right. And as Cassandras like Nouriel Roubini know, it can sometimes take longer than you anticipate for bad policies to finally yield the expected dismal harvest.