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Sunday, April 06, 2008

Alan Greenspan: The Fed is Blameless

Alan Greenspan says to quit blaming the Fed for the housing bubble:

The Fed is blameless on the property bubble, by Alan Greenspan, Commentary. Financial Times: I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long-term interest rates statistically explains, and is the most likely major cause of, real estate capitalisation rates ... that declined and converged across the globe. ...

[S]ome point to Federal Reserve monetary policy complicity in the US bubble. But ... the evidence that monetary policy added to the bubble is statistically very fragile. Paul De Grauwe ... conclude[s] that the low funds rate was the source of the US housing bubble. ... De Grauwe asserts that “signs of recovery” ... were evident before 2004 and hence the Fed should have started to tighten earlier. With inflation falling to quite low levels, that was not the way the pre-2004 period was experienced at the time. As late as June 2003, the Fed reported that “conditions remained sluggish in most districts”. Moreover, low rates did not trigger “a massive credit ... expansion”. ...

Bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do bank regulators. Regulators, to be effective, have to be forward-looking to anticipate the next financial malfunction. This has not proved feasible. ...

Aside from far greater efforts to ferret out fraud..., would a material tightening of regulation improve financial performance? I doubt it. The problem is not the lack of regulation but unrealistic expectations about what regulators are able to prevent. ...

The core of the subprime problem lies with the misjudgments of the investment community. Subprime securitisation exploded because subprime mortgage-backed securities were seemingly underpriced ... at original issuance. Subprime delinquencies and foreclosures were modest at the time, creating the illusion of great profit opportunities. Investors of all stripes pressed securitisers for more MBSs. Securitisers, in turn, pressed lenders for mortgage paper with little concern about its quality. Even with full authority to intervene, it is not credible that regulators would have been able to prevent the subprime debacle.

Martin Wolf argues in the FT that central banks “can surely lean against the wind” even if they cannot eliminate bubbles. I know of no instance in which such a policy has been successful. ... I doubt that it is possible. If it turns out to be feasible, I would become a strong supporter of “leaning against the wind”. ...

Much of the commentary critical of my FT article (Comment, March 17) is directed less at its substance and more ... at “the ideology I display”. Ideology defines that set of ideas that we each believe explains how the world works and how we need to act to achieve our goals. ...

I do have an ideology. ... I trust our views are subject to the same standards of evidence that apply to all rational discourse. My view of how the efficiency of global capitalism has evolved over the decades as new evidence has appeared contradicts some earlier judgments and confirms others. I have been surprised by the fierceness of investors in retrenching from risk since August. My view of the range of dispersion of outcomes has been shaken but not my judgment that free competitive markets are the unrivalled way to organise economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?

I'll turn the criticism of the position that the Fed is blameless over to Steve Waldman:

Central banks are dangerous, by Steve Waldman: I really thought that Michael Shedlock was overstating the case:

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing...

Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem...

The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

But then I read this piece, by Robert Shiller (hat tip Yves Smith), and all of a sudden I'm frightened. It's one thing when Hank Paulson proposes turning the Fed into the macroeconomy's philosopher king. Paulson will be gone in a blink of an eye. But Robert Shiller is an increasingly influential economist. He's already got Mark Thoma signed up for the plan. These guys are smart, they matter, and they will continue to matter next January. So let's think about this very, very carefully.

Shiller points out that...

In recent years, central banks have not always managed macro confidence magnificently. The Fed failed to identify the twin bubbles of the last decade — in the stock market and in real estate — and we have to hope that the Fed and its global counterparts will do better in the future. Central banks are the only active practitioners of the art of stabilizing macro confidence, and they are all we have to rely on.

He's right on both counts. For now, central banks are all we have to prevent a catastrophic unwinding of our unstable financial system. But they had everything to do with getting us here. It's not just the Fed, with its famous "serial bubble-blowing", its cheering on of any novelty as beneficial innovation, its absolute refusal to peer into the magical sausage factory that Wall Street had become. The problem with central banks is much bigger than that. If you haven't been obsessing over every word Brad Setser has written for the past several years, you owe yourself an education. A growing "official sector" has largely defined the global macroeconomy in the first years of this millenium. In the USA, Japan, China, Europe, central banks have indeed been "active practitioners of the art of stabilizing macro confidence". For most of those years, it seemed like they were succeeding. They were never succeeding. Call it what you want, call it "Bretton Woods II", call it "financial imbalance" or a "global savings glut" or "exorbitant privilege". Each central bank, while trying to stabilize its own bit of the world, found itself with little choice but to support and expand unsustainable financial flows on a scale so massive they have reshaped the composition of every major economy on the planet. As Herb Stein told us, what cannot go on forever won't. "When the music stops, in terms of liquidity, things will be complicated." Remember that? The music may have stopped already for Citibank, but it's still playing for the USA. The record is just beginning to skip. ...

Things may turn out okay. We've already begun to "adjust", and knock on wood, we'll manager a worldwide reequilibriation before things get too ugly. But it'll be a close call. That financial alchemy by central banks is the ultimate source of skyrocketing inflation in China and the Gulf states, and an ominous sign that Stein's Law is beginning to bite. We may yet escape, but we have been drawn very close to something very dangerous, to a genuine crisis of scarcity in the United States and a catastrophic failure of Say's Law in China, to mass unemployment, social instability, and fingers and missiles pointed in both directions across the Pacific. This is serious stuff. And central banks are largely to blame.

Private, profit-seeking actors would not have generated the corrosive financial flows that have characterized this millennium. "Financial imbalance", a euphemism for real resource misallocation, would have quickly been corrected, had Wall Street and the City of London not learned that the official sector could be their best customer. Less politically-independent monetary authorities could have leaned against unsustainable financing. A bit of capital-account protectionism might not have been bad policy for the United States during this period, but a central bank blind to obvious "facts on the ground", accountable only to an economic orthodoxy, did not even consider such a thing.

As readers of this blog know, I'm not a laissez-faire, the-private-sector-is-always-right kind of guy. I like to think about the "information architecture of the financial system". That leads me to dislike actors large enough to unilaterally move markets, especially when their motives might not be aligned with wise resource allocation. I dislike large private banks, and think they should be broken into itty-bitty pieces or turned into safe, regulated utilities. For the same reason, I dislike central banks. They have the power to act consequentially, but they do not have, and cannot have, the information or the wisdom to always be right. And when they are wrong, the consequences are devastating.

So, what to do? For now, we have no choice but to "use the army we have". Our long-term plan, though, ought not be to canonize central banks, but to render them obsolete. It won't be easy. The usual "sound money" trope, reviving the gold standard, is not a good idea. Much as it is suddenly out of fashion, we will need some "financial innovation" to build a new monetary architecture. Just because we've had a glut of snake-oil on the market recently doesn't mean there's no such thing as penicillin. We'll have to do a better job of distinguishing novel idiocies from good ideas. But we will need the good ideas. We can and should liberate money from the bankers, central and otherwise.

I don't think we will be rid of the Fed, or some version of it, any time soon, so right now the Fed has two choices on the regulatory front. Do nothing and hope that financial markets fix themselves - that seems to be the Greenspan position - or do something. I don't think this will fix itself so that the problems cannot reoccur, so we have to do something. But what?

I believe that Shiller is right to say that financial institutions have changed substantially since the inception of the Fed's main regulatory powers around seventy five years ago. We need to broaden our concept of what a bank is, and broaden the Fed's authority to regulate financial institutions to fit this updated definition of what defines a bank. If we look at the financial instability in the U.S. prior to the existence of the Fed, particularly once its powers were broadened after the Great Depression, there is little doubt that the Fed has promoted stability and confidence in the financial sector. No, the Fed isn't perfect, and it won't be able to prevent all instabilities with regulation or any other means, there will be good and bad times. But over the entire period the Fed has been in existence, financial markets have done fairly well, and with an effort to learn from our mistakes and update the Fed's regulatory authority to be consistent with modern financial markets, we can hope for relatively stable markets in the future.

I don't think the correct lesson to be learned from the entire history of the Fed's interaction with financial markets is that we should take away the Fed's regulatory authority because it has failed us when we needed it most. It didn't react very well during the Great Depression, but we learned, the Fed evolved, imposed new policies and new regulation, and we enjoyed a much more stable period afterward. When stock markets crashed in later years and reserves began falling (or, say, during 9/11), the Fed knew how to react, injected reserves, and prevented major problems. We were better off because the Fed was around to offset the fall in reserves. The Fed didn't react very well during the 1970s when we were hit with oil price shocks, but the Fed learned, and recent shocks have had a much different impact (to be fair, that's partly due to a changed economic structure, so it wasn't all changes in how the Fed reacted).

There are many instances where we see the Fed not reacting as well as we might hope the first time it encounters a problem, learning, and then doing better the next time. I see no reason to expect the present episode to be any different. We need a larger overhaul than in many past instances because we allowed the Fed's authority to fall far behind changes in financial markets - we didn't recognize soon enough how far out of date the Fed's authority had become. But we know now, and we'll do our best to plug the holes. We might not anticipate the new problems that will invariably arise, the ones never seen before - those are hard to see coming - but if the conditions that led to our present problems reoccur in the future, the Fed will be in a much better position to prevent them from erupting into bigger problems if we learn from the present and update its authority as needed.

I'm not ready to give particulars just yet (and your thoughts are very welcome), but as I think about the changes that are needed, a first step is, as noted above, to broaden our definition of what a bank is, and to broaden the Fed's regulatory authority over such institutions. Second, risks need to be made as transparent as possible, and there are many, many steps we can take along these lines. Regulation to ensure that market participants have the information they need to make good decisions, e.g. disclosure requirements, truth in labeling, etc., have been very successful in improving how markets function in other settings, so there may be hope that these types of regulations could do some good here as well. With transparency and known risks, better decisions will be made, and there's less need for other types of regulation to prevent excessive risk accumulation. As a third step we need to ensure that no single financial institution, or no small set of institutions, can be so important that the entire economy is at risk if one or a few of them fail. This is a significant vulnerability, but I'm not fully certain how to proceed. Steve Waldman's ideas to break up financial institutions into smaller pieces or regulate them like utilities are worth considering along with other approaches, but whatever approach we take, we should not be so dependent on the fortunes of such a small number of firms, and we should do our best to find a way to reduce this vulnerability without sacrificing our ability to channel funds where they are most needed. [Let me add: Even if there are no vulnerabilities due to the existence of one or a few large firms that are too important too fail, it is still possible that a shock to the entire financial system could cause widespread losses and require the Fed to intervene to prevent a complete collapse. So we should also look for ways to prevent system-wide vulnerabilities due to the accumulation of risks that are common across firms. The Fed should be concerned when there is a concentration of risk for any reason, e.g. due to very large, "too important to fail" firms, or due to a build-up of common risk factors that can cause widespread failure of financial institutions, because when risk is concentrated, there is the potential for financial collapse.]

    Posted by on Sunday, April 6, 2008 at 05:58 PM in Economics, Financial System, Monetary Policy, Regulation | Permalink  TrackBack (0)  Comments (41)

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