Sunday, May 18, 2008

Don't get hopeful about Fed interest in asset bubbles

(Naked Capitalism) There has been a raft of articles about the Federal Reserve's new found interest in the question of asset bubbles, suggesting that the Fed might be ready to shift policy and exhibit more willingness to rein them in. Yesterday, a page one Wall Street Journal story discussed at length research central bank chairman Bernanke has sponsored at Princeton, and noted:
The Fed is giving the activist approach some thought. In a speech scheduled for delivery Thursday night, Fed Governor Frederic Mishkin suggested that while it was inappropriate to use the blunt instrument of interest-rate increases to prick bubbles, if too-easy credit appeared to be fueling a mania, policy makers might craft a regulatory response that could "help reduce the magnitude of the bubble."

Doug Noland at Prudent Bear takes issue with the view that the Fed might be changing its approach and gives a close reading of the Mishkin speech:
The conclusions from Professor Mishkin’s paper differ only subtly from previous doctrine:
First, not all asset price bubbles are alike. Asset price bubbles that are associated with credit booms present particular challenges....Second, monetary policy should not try to prick possible asset price bubbles...Instead, monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability… Third, because asset price bubbles can arise from market failures that lead to credit booms, regulation can help prevent feedback loops between asset price bubbles and credit provision. Our regulatory framework should be structured to address failures in information or market incentives that contribute to credit-driven bubbles.

Mishkin suggests regulatory remedies might help prevent unhealthy booms, but even the ideas he presents as possible solutions are minimal. Information failures? The research described in the Journal article essentially said that investors get overly excited about a broad scale innovation and start bidding up prices of related investment opportunities beyond realistic levels. Those with more cautious views step aside, unwilling to get killed, until the bulls exhaust themselves. Pray what information failure can you point to in that? The negative information is out there, just as it was during the housing bubble. But it was ignored. Mishkin is pointing to instrument-specific misunderstandings, as with investors buying MBS and CDOs, they really didn't understand. But what information failure was there in the dot-com era? It was clear to all that the vast majority of companies had no realistic prospect of turning a profit, yet ownership of "eyeballs" became the new version of tulip mania.

Back to Noland:
I’ll posit this evening that the entire issue of “central bankers vs. asset Bubbles” has become little more than A Red Herring. While it is as of yet too early in the unfolding financial and economic crisis for “consensus opinion” to have reached a similar conclusion, in reality contemporary monetary management can already be proclaimed an unmitigated failure. Cloaked in ideology and a flawed conceptual framework, the Greenspan/Bernanke Fed sat idly by as history’s greatest Credit inflation and myriad resulting Bubbles irreparably damaged the underlying structure of the U.S. Credit system and real economy (before going global). And while the Fed executes its latest round of post-asset Bubble “mop up,” precarious Credit Bubble dynamics are left to run similar roughshod through global financial and economic systems. Better to downplay the asset Bubble issue for now, as we contemplate the nature of what will be a much altered post-Global Credit approach to central banking.

From Mishkin:
The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.

In no way do I believe “the ultimate purpose of a central bank” is to “foster economic prosperity,” and I certainly don’t expect any such grandiose mandates to survive in the post-Bubble environment. On many levels the notion that central bank policies are instrumental in creating prosperous economic conditions is problematic. For one, it grossly over promises in regard to the long-term benefits derived from government manipulation of interest-rates. Secondly, it virtually guarantees an accommodative policy regime and, inevitably, a strong inflationist bias. Thirdly, such a nebulous objective invites overly discretionary policymaking, along with an activist and experimental approach to monetary management. Fourthly, such an approach ensures that policymaking errors beget greater and compounding errors.

Noland is correct to point to the dangers of continued Fed mission creep. Noland again returns to quoting Miskin:
From Mishkin:
After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative. …If monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small. More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.

This passage, in particular, goes right to the heart of several key failings of current doctrine...The problem with post-asset Bubble “accommodation” is that it specifically accommodates the very Credit infrastructure and related Monetary Processes that financed the preceding boom. It works to validate the present course of financial innovation (think “Wall Street securitizations,” “CDOs” and “carry trades”), while emboldening those at the cutting edge of risk-taking (think “leveraged speculating community”).....

Moreover, a commitment to aggressively cut rates in response to faltering asset Bubbles openly courts leveraged bond market speculation – a market dynamic that engenders artificially low market yields and exacerbates liquidity excess during the late-stage of asset bubbles (think bond market “conundrum”). The last thing a central bank should encourage is an entire industry dedicated to placing leveraged bets on the direction of Federal Reserve policy responses...

The overriding flaw in the Greenspan/Bernanke approach has been to openly disregard Credit Bubble dynamics, in particular the increasingly profound role being played by Wall Street-backed finance in fueling Credit, market liquidity and speculative excesses. I believe The Ultimate Objective of a Central Bank is to Foster Monetary Stability in the broadest sense. In this regard, asset Bubbles should be viewed primarily as important indicators of some type of underlying Monetary Disorder. The key analytical focus must be on the underlying Credit and speculative dynamics fueling the asset price distortions – to better understand and rectify the source of “disorder” – and the earlier, the better.

The most dangerous policy approach is to further incentivize a system that has already demonstrated a proclivity for Credit and speculative excess – employment, output and “deflation” concerns notwithstanding....

Greenspan, Bernanke, Mishkin and others repeatedly stress the inability of policymakers to recognize the existence of a Bubble until after it pops. It is my view that the entire notion of asset prices dictating monetary policy is flawed. The focus should instead be on the underlying sources of monetary fuel – the Credit growth and financial flows underpinning asset inflation and economic boom....

Central bankers can and should avoid being in the difficult position of having to respond directly to inflating asset markets. Instead, there must be carefully fashioned, communicated and administered “rules of the game”. To begin with, it is incumbent upon the Fed to clearly articulate to the public (and their elected officials) the overwhelming benefits of stable Credit and financial conditions. It must be conveyed that Credit and speculative excesses are destabilizing, fostering boom and bust dynamics and structural impairment. The public must come to appreciate that the effects of destabilizing Credit inflation come in many forms, including asset price inflation and Bubbles, Current Account Deficits, currency debasement, traditional consumer price inflation, and various distortions to underlying Financial and Economic Structures.

Volcker could carry this off, as possibly could have earlier former non-academic Fed chairmen (ie, not Arthur Burns). But it seems the Fed has been badly, hopelessly captured by the industry, which is the converse of what is desirable. Unless a new President is able to find and slowly restock the Fed with men and women with some good old fashioned probity, the instability and propensity to financial excess will only get worse.

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