"How to Prevent the Great Depression of 2009"

Roger Farmer says the Fed needs to target an asset price index "to prevent bubbles and crashes":

How to prevent the Great Depression of 2009, by Roger E.A Farmer, Financial Times: ...Since world war two, economic policy in most western democracies has been based on Keynesian economics. But although policy makers still rely on Keynes' ideas, academics gave up on his theories 40 years ago and went back to classical economics... The result has been 40 years of disconnect in which policy makers are tinkering with the engine without a manual. ...

We have seen economies stagnate for a decade or more in the past - the UK in the 1920s, the US in the 1930s and Japan in the 1990s - and it would be presumptuous to think that this cannot happen again when the existing dominant paradigm says that it could not happen in the first place.

Classical economists argue that falling wages will restore equilibrium; but this is based on the belief that the labour market works like an auction in which employment is determined by demand and supply.

It ignores the very real frictions involved in searching for a job by both households and firms that can lead to many possible equilibrium employment levels just as Keynes argued in the General Theory. ...

So where do we go from here? The only actor large enough to restore confidence in the US market is the US government. The current policy of quantitative easing by the Fed is a move in the right direction but it does not, as yet, go nearly far enough.

It is time for a greatly increased role for monetary policy through direct intervention of central banks in world stock markets to prevent bubbles and crashes. Central banks control interest rates by buying and selling securities on the open market.

A logical extension of this idea is to pick an indexed basket of securities: one candidate in the US might be the S&P 500, and to control its price by buying and selling blocks of shares on the open market.

Even the credible announcement that a policy of this kind was being considered should be enough to boost the markets and restore consumer and investor confidence in the real economy.

Critics will argue that this policy is dangerous socialist meddling. But I am not arguing that the government should pick winners and losers: only that it should stabilise a broad basket of stocks.

This policy would still allow poorly run firms to fail but it would not allow all firms to fail at the same time. Although the free market is very good at deciding how many left and right shoes to produce, it cannot prevent systemic risk that arises from the psychology of herd behaviour. This is a job for Uncle Sam.

As I've noted many times, most recently here, I am also warming up to the idea of having the Fed target an asset price index in addition to inflation and unemployment. But there are lots of questions to be answered first. What growth rate in the stock price index should we target? Should it be 8%? Lower? Higher? What is the correct time frame? Day to day fluctuations are quite volatile, we wouldn't want to react to every movement in the index, so how do we come up with a core measure that gives us an indication of the long-run trend in stock prices? Does value weighting, as in the S&P 500, give the optimal index, or would some other weighting scheme do better? Do we only include financial assets, or should other asset prices such an housing price index also be targeted? If so, how would we do that? When targets are in conflict, how much weight should deviations of the asset price index from its target value be given relative to deviations of inflation and output from their target values? Will it still be true that it is optimal for the Fed to react by raising the federal funds rate more than one to one in response to changes in inflation? How will adding another source of variation to the federal funds rate affect its smoothness? We don't fully understand why interest rate smoothing is an important component of the Taylor rule, but it does seem to be an important, so how will this change will affect smoothness (it depends upon how the coefficients in the Taylor rule are adjusted after the new piece is added)?

And that's just a few of the questions, I'm sure I've overlooked many more (and please feel free to fill in the missing pieces in comments). Thus, while I certainly think this is a fruitful area to investigate, particularly in light of recent experience with the housing and stock price bubbles, we have more thinking to do and more regressions to run before we are ready to implement this kind of policy.

Finally, even with theoretical and empirical support, I'd be wary that asset price targeting alone will be enough to prevent problems in asset markets from developing in the future. Asset price targeting is a complement to other measures such as regulatory and enforcement changes, not a substitute, and I think it would be a mistake to believe simply twiddling with the policy rule will be enough to avoid another financial market meltdown that threatens the wider economy.

Update: Barkley Rosser, in comments, with an opposing view:

I spoke on the matter of "battling bubbles" at the Galbraith conference in New York.  In November.  I specifically suggested not doing something like this, or more generally not trying to use broad interest rate policy to influence speculative markets.  However, I did support more targeted interventions in specific markets where there was good evidence of a serious speculative bubbles.  I argued for using more specific regulatory tools along the lines suggested by Robert Feinman, such as changing margin requirements, or for housing tightening rules on mortgages, or for commodities, using buffer stocks (Strategic Petroleum Reserve, etc.) for interventions.

The real downside of using broad monetary policy to tamp down general stock market bubbles has been seen.  It was called the Great Depression. 

Also, keep in mind that we have not had a stock market bubble in recent years.  We have had bubbles in housing and in oil and in some other commodities, but the P/E ratios have been pretty reasonable.  The recent plunges of the stock market are not crashes of bubbles (the 2000 decline was, especially for dotcom stocks).  Rather these are fundamental declines based on rationally expected declines in future profits and dividends.

Oh, and I do not see setting any sort of rule for this sort of thing as making any sense.  It will have to be discretionary and case by case, keeping in mind that any such interventions will always be strongly opposed by those who are in the middle of making money from the bubble.

Update: Tyler Cowen adds to the dissenting voices.

Update: Given the recent discussion about whether the current recession is due to a reduced willingness to work, I debated leaving this line about "contagious laziness" in, but didn't. Angus at Kids Prefer Cheese fills the void:

Wow, speaking of Laziness.....: Roger Farmer writing December 30th 2008 in the FT:

"In classical economics, the prices of stocks are determined by fundamentals and the fundamentals of the economy are sound. The US had the same stock of factories and machines in August that it had in July and the US workforce has not been afflicted by a sudden attack of contagious laziness."

Franco Modigliani writing in the AER, March 1977:

"Sargent (1976) has attempted to remedy this fatal flaw by hypothesizing that the persistent and large fluctuations in unemployment reflect merely corresponding swings in the natural rate itself. In other words, what happened to the United States in the 1930's was a severe attack of contagious laziness!"

Ouch! Can't one of the all-time greats of Macro get any love in this day and age???

Update: Discussion continues here.