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Tuesday, April 15, 2008

"Greenspan's Follies"

Stephen Roach says Alan Greenspan is "guilty as charged":

Greenspan’s Follies, by Stephen S. Roach, Foreign Policy: There’s just one problem with Alan Greenspan’s attempts to defend his record on the financial crisis: The former Fed chairman is guilty as charged. ... Greenspan’s blend of politics and ideology led to bad economics and a succession of policy blunders whose severity is only now becoming clear.

Greenspan’s handling of the housing bubble is the smoking gun. The Greenspan mantra is that markets know best—that central bankers should not attempt to override the verdict of millions of market participants by declaring that an asset bubble has formed. After all, there are the costs to economic growth to consider if monetary policy is used to deflate such bubbles. And why should any modern economy have to incur those costs? After all, goes the script, the authorities always have the wherewithal to clean up any post-bubble mess. Maybe not. This time, the mess is almost beyond the realm of comprehension—most likely a good deal larger than any growth that might have been foregone had the U.S. housing bubble been handled more judiciously. ...

One of the weakest links in the Greenspan defense is his fixation on whether a serious bubble was forming in America’s housing market. Never mind his earlier arguments that housing markets were local, not national, and that it was highly unlikely that home prices could ever fall nationwide. Whoops. Never mind also his equally irrelevant point that there were lots of housing bubbles in the world at the same time... Everyone’s doing it, so it’s not the Fed’s fault. Right?

Wrong. The trouble with America’s housing bubble was never its comparison with Ireland. The core of the problem lies in the distortions that asset bubbles created on the real side of the U.S. economy. Courtesy of the most rapid rates of sustained U.S. house price appreciation in the modern post-World War II era, along with innovative financing techniques that allowed American homeowners to extract equity with ease..., the new age of the asset-dependent consumer was born. ...

Increasingly supported by the confluence of both property and credit bubbles, U.S. consumers spent well beyond their means. Personal consumption climbed... At the same time, household debt soared... America certainly achieved the rapid growth that Greenspan felt the body politic wanted. But it was growth based increasingly on fumes. ...

Saving rates plunged to zero for the first time since the Great Depression. An increasingly asset-dependent U.S. economy then had to borrow surplus saving from places like China ... Greenspan and his disciple Ben Bernanke saw this situation exactly backwards. America, they insisted, was simply doing the rest of the world a huge favor by absorbing its surplus saving. Serious dollar risks were characterized as a problem for a distant day. Suddenly, that day doesn't seem so distant.

What Greenspan missed repeatedly over the years ... are the corrosive impacts this bubble had in fostering the imbalances and excesses of an asset-dependent U.S. economy. ... Global imbalances are also an outgrowth of this era of excess—underscored by America’s massive external deficit and, by the way, the protectionist fires it stokes. Alas, these fault lines were made all the deeper by the Fed’s regulatory laxity in an era of unprecedented financial innovation—a laxity made all the more dangerous by the cheap borrowing costs of a Fed-induced credit bubble. ...

It didn't have to be this way. Just saying no to asset bubbles was always an option. A variety of anti-bubble tools—the bully pulpit of jawboning, more disciplined regulatory oversight, and, ultimately, a tighter monetary policy—could have prevented disaster. Yes, economic growth would probably have been slower, but that shortfall likely pales in comparison to the post-bubble carnage now before us. Too bad Greenspan couldn’t bring himself to follow the sage advice of one of his predecessors at the Fed and “take away the punch bowl just when the party was getting good.” ... The legacy of Alan Greenspan will be forever tarnished by this dangerous and painful reality check.

I've been meaning to cover the topic of whether the Fed should target asset prices, and with the repeated charge that the Fed should have let the air out of the housing bubble I've been hearing lately, now seems like a good time.

I have not been in favor of the Fed using monetary policy to try to prevent asset price bubbles. But there is a sense in which I think they should do this.

First, a bit of background. The point of monetary policy in New Keynesian models of sluggish wage and price adjustment, the framework I'll use here, is to shut down misleading price signals. The flow of resources in the economy is dictated by relative prices, i.e. the price of good A divided by the price of good B (e.g., the number of loaves of bread you can get for a gallon of gas), and when there are sticky prices and sticky wages, inflation can push relative prices away from their long-run, equilibrium levels. Inflation requires all prices to move in proportion, and changing local conditions require prices to move differentially, but the presence of price rigidities prevents these adjustments causing relative prices to move away from their desired values. This sends false signals to both input and output markets, resources go to the wrong places, the wrong goods are produced, at some point the resources must be redirected, and all of this makes us worse off.

The policy solution is to try to make sure that relative prices do not deviate from their optimal values. How do you do that? Here's Michael Woodford:

The theory ... provides important insights into the question of which price index or indexes it is more important to stabilize. Again, the answer depends on the nature of the nominal rigidities. If prices are adjusted more frequently in some sectors of the economy than in others, then the welfare-theoretic loss function puts more weight on variations in prices in the sectors where prices are stickier... This provides a theoretical basis for seeking to stabilize an appropriately defined measure of "core" inflation rather than an equally weighted price index. ... Similarly, if wages are sticky as are goods prices, ... then instability in the rate of growth of a broad index of nominal wages results in distortions similar to those created by variations in goods price inflation. ... In this case, optimal policy involves a tradeoff between inflation stabilization, nominal wage growth stabilization, and output-gap stabilization...

Thus, according to this, to stabilize the economy you first create a price index - call it core CPI or core inflation - that contains only the inflexible prices and leaves out the flexible prices (or better, uses weights that increase with the degree of inflexibility - thus, the price index the Fed targets will be different from the CPI or other measures of the cost of living which use a different set of weights). A similar core index is created for wages. Monetary authorities then use policy to target the core indexes for prices and wages so that they are as stable and as predictable as possible, and this allows the flexible prices to adjust in response to changing conditions and keep relative prices as close as possible to their optimal values.

Theoretically, the monetary policy rule should include deviations of the core indexes for prices and wages from their target values. Whether the prices of financial assets such as stocks and bonds should also be indexed and targeted is an open question, but theoretical results mostly point to leaving the asset price index out of the stabilization equation, and this has been the approach the US central bank has followed (against the advice of people like Steven Cecchetti).

The core price index the Fed uses does not include the asset value of houses, but it does have an imputed value for housing services the household consumes each time period, i.e. the opportunity cost of living in an owner occupied house. However, this imputed value has not always tracked housing prices very well, and it appears to suffer from measurement error.

I think two things ought to be considered. First, housing prices are sticky, at least in the downward direction where they are very sticky, and this makes the value of housing services sticky as well. Thus, this value should be included in the core price index the Fed targets. However, the imputed value used now appears to be flawed, and it needs to be reexamined and improved. Precision here is important (I would also consider using a measure that tracks actual housing prices better. I'm assuming more precision would do that, i.e. lead to more stable rent/price values, but if not I'd also take a weighted average of housing services and housing prices, or use some other scheme to make the measure used in the core index track housing prices better than it does now). Second, the Fed needs to pay more attention to housing prices as reflected in (an accurate measure of) housing services - this component needs to have a larger weight in the overall index.

With these changes, more precision in the measurement of the value of housing services, better tracking of actual housing prices, and more weight on the measure of the cost of housing services in the core index the Fed targets, any run-up in housing prices will cause a larger deviation of core inflation from its target value and bring a stronger interest rate response from the Fed. Thus, to some degree, the Fed will let the air out of the housing bubble automatically whenever rising housing values cause the core inflation index to start rising above its target value. This isn't quite the same as targeting asset values directly, and it only indirectly gets at one asset - housing - but it would lean against housing markets a little more than we do now.


[Note: A quick search brings up this 2006 paper by Mishkin and Schmidt-Hebbel summarizing views on asset prices and monetary policy:

Monetary Policy Under Inflation Targeting: An Introduction, by Frederic S. Mishkin and Klaus Schmidt-Hebbel: ... 1.5 Asset Prices and Monetary Policy under Inflation Targeting A heated debate has taken place in recent years regarding the optimality of monetary policy—whether under inflation targeting or alternative monetary regimes—to react to asset prices or perceived asset price misalignment. Cecchetti and others (2000) argue that reacting to asset prices, in addition to inflation and the output gap, is likely to achieve superior performance and a smoother inflation path by reducing the likelihood of an asset price bubble. (This view was restated by Cecchetti, Genberg, and Wadhwani, 2002, in their response to some of the counterarguments presented next.) Much of the academic and policy literature reacted with skepticism to their proposal. Bernanke and Gertler (2001) contend that reacting to equity prices is counterproductive (over and above its effects on inflation and the output gap), while Batini and Nelson (2000) state that reacting to the exchange rate is not optimal (over and above its effects on inflation and the lagged interest rate). A related argument holds that since inflation-targeting central banks focus on inflation expectations, they need not target asset prices directly, but rather can use them to improve their prediction of the path of future inflation (Bean, 2003). Most inflation-targeting (and other) central banks have thus far sided with the skeptical view on monetary policy reaction to asset prices. Reasons for skepticism include the difficulty of measuring asset price misalignment, the difficulty of anticipating future asset price booms and busts or the future effects of preventive nonmonotonic policy actions, the difficulty in discriminating among different asset prices (such as housing prices, equity prices, and the exchange rate), and the possible dilution of the inflation objective.]

    Posted by on Tuesday, April 15, 2008 at 03:45 AM in Economics, Financial System, Housing, Monetary Policy | Permalink  TrackBack (0)  Comments (26)

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