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Friday, October 26, 2007

Axel Leijonhufvud: Bubble, Bubble, Toil and Trouble

Axel Leijonhufvud on the linkages between monetary policy and financial instability. He argues that "Inflation targeting might mislead us into pursuing a policy that is actively damaging to financial stability":

Bubble, bubble, toil and trouble, by Axel Leijonhufvud, Project Syndicate: Editors’ note: This is shortened version of the author’s Policy Insight “Monetary and Financial Stability“.

As recently as twenty-five years ago, monetary stability in the United States was based on the Federal Reserve System’s control of the quantity of money. Financial stability was ensured by the comprehensive regulations of the Glass-Steagal act. Today, these regulations are gone and a great wave of innovations has entirely changed the financial landscape. And we no longer know how one might define the “quantity of money” for control purposes.

In this new environment, price level stability is supposed to be taken care of through inflation targeting while financial stability is supposed to take care of itself given the many new ways of diversifying and trading risk that have evolved since deregulation.

Inflation targeting is an adaptive strategy keyed on movements of the inflation rate. If inflation rises, the Central Bank should counter by raising the interest rate. The presumption is that, if the inflation rate is low and steady, monetary policy is “just right.” Acting on that presumption in a period during which CPI-inflation in the U.S. was stabilised largely through the exchange rate policies of major trading partners, the Federal Reserve System kept its rate too low for too long. The result has been asset price inflation, high leverage ratios in the financial system and widespread deterioration of credit standards (See VoxEU, June 27: “The Perils of Inflation Targeting,”). This is the legacy with which markets and policy makers are now struggling.

Securitisation and risk transfer instruments were supposed to have made the financial world a safer place. But although securitisation dispersed risk away from the banks where it used to be concentrated, in the system as a whole there is more of it, it is less transparent and we know less about how it is distributed. Losses in the subprime mortgage market started to mount already in the Fall of 2006, but it was only after some prominent funds failed in late June that the credit crisis became general as the asset-backed commercial paper and the interbank markets froze up. Suddenly, assets which had been eminently marketable at short notice yesterday had no ascertainable market value today in the total absence of buyers. Three months later the panic that gripped Wall Street has eased but much toil and trouble remain before the overall size of losses and their final distribution are worked out.

There has been much brave talk about the “real economy” still going strong as if finance were no more than froth on its surface. But if the economy has to go through a period of substantial de-leveraging, as seems more than plausible, a recession is inevitable. If everyone, on average, tried to buy less and sell more in order to reduce indebtedness, the result has to be excess supply of goods and services, falling prices and rising unemployment.

Beyond the immediate prospects, Central Banking doctrine needs to be reconsidered. What recent experience has now demonstrated is that a monetary policy, which succeeds in keeping the CPI inflation rate on target, may still do damage. But many adherents of inflation targeting have been adamant that central banks should not let themselves be led astray by asset prices since what is or is not a bubble cannot be known in advance of it actually popping. (Is deterioration in credit quality equally ambiguous, one wonders? Or might ninja loans be at least a clue?) This attitude is strongly reinforced by the political pressures on policy makers. When a bubble is inflating, all the institutions and individuals who see themselves getting rich will oppose any Central Bank attempt to deflate it – with no countervailing interest of political consequence on the other side. After the bubble has burst, however, the political pressures are all for the Bank to pick up the pieces.

This political asymmetry is all the worse because of the economy’s asymmetric response to policy. It is easy to feed a bubble but very hard to reflate it once it has burst. Greenspan managed to reflate after the dot.com bust, but Japan’s inability to do so for so many years after its double crash in 1990 is a more ominous example.

A further exacerbating factor is the cyclical asymmetrical response of the major financial institutions. Risk managers lose influence on the upswing and only regain it after a bust.

No big exogenous shock set the current crisis in motion. What this almost certainly means is that the occurrence of crises is an endogenous property of the world financial system as we have let it evolve over the last twenty-some years. The various asymmetric responses noted above would tend to impart this kind of behaviour to the system. The summer of 2007 experience will no doubt induce some regulatory changes. But it is safe to assume that they will be of marginal significance –  which means that we have other crises coming down the pike towards us.

The Fed has had enough trouble explaining why it looks at core rather than headline inflation, but nevertheless, I've wondered if the price index used to set monetary policy ought to be broadened to include both wages and asset prices (one example is here, but I don't think the weight used on the three components, consumer prices, producer prices, and asset prices, is necessarily correct). However, Jean-Claude Trichet, President of the ECB, calls this view extreme and says it's a bad idea:

Targeting asset prices One extreme view attributing a more prominent role to asset prices in the conduct of monetary policy is to include asset prices in the consumer price index used to define the policy objective.[21] ... Today there is something close to a consensus among economists and central bankers that targeting financial asset prices is a bad idea. ... First, in reality asset prices are a bad proxy for future CPI inflation, as asset price changes are driven by changes in fundamentals and not only inflation expectations. Second, targeting asset prices would increase risk-taking by private agents in anticipation of the attempts of monetary policy to stabilise asset prices. This is the well-known moral hazard argument. Third, with rational forward-looking private agents, there is the possibility of a circular relationship between monetary policy and asset prices. Asset prices would partly determine monetary policy, while simultaneously expected future monetary policy determines today’s asset prices. As a consequence, inflation could be purely determined by self-fulfilling market expectations and thus become extremely volatile. This problem is known as “inflation indeterminacy”. Fourth, if the central bank targets CPI inflation by means of a successful monetary policy strategy taking into account all indicators of inflationary pressure (including signals from asset prices), targeting asset prices directly would amount to double-counting inflationary pressure derived from asset prices. Fifth, the weight for asset prices in a combined price index is ambiguous... And finally, central banks lack sufficient control of asset prices. In the long run, asset prices are driven by fundamental factors and not monetary policy.

    Posted by on Friday, October 26, 2007 at 11:43 AM in Economics, Financial System, Housing, Monetary Policy | Permalink  TrackBack (0)  Comments (7)

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