By Nick Li
Whither monetary policy?
Back in 2006 it seems like the industrialized world had achieved a consensus on monetary policy. There was an independent central bank whose primary objective was to maintain price stability, either through direct inflation-targetting (say, keeping the prime rate between 1% and 3%) or through a general objective of "price stability" sometimes counterbalanced by maintaining the economy near full employment. And despite tremendous criticism from some quarters in the aftermath of the 2007-201? financial crisis and recession, Alan Greenspan and Ben Bernanke (after 2006) did exactly that, as did the European Central Bank (with the important caveat that unemployment varies tremendously across European countries and the ECB tends to be more oriented towards the biggest economies of the Euro area, especially Germany). Unemployment was around 5% in the US and inflation (as measured by the Consumer Price Index) was low and stable.
Yet in the aftermath of the crisis, there has been a lot of debate about whether the Central Banks did enough to avert the crisis and whether their role might extend beyond simply setting interest rates to maintain stable inflation, especially since with interest rates near zero, conventional monetary policy has little power to affect the economy and boost employment in the current global recession. In this article I will briefly review some of the current proposals and debates.
Punchbowlism vs. the Designated Driver
At the heart of the debate is the question of whether Central Banks have a responsibility to intervene pre-emptively or whether it is sufficient to intervene after the fact. Think of the economy as a huge party where during the boom everyone is getting pissed drunk (or snorting coke off a CDS). The punchbowl school says that as the economy is beginning to get really wasted, the Central bank has to take away the punchbowl – the liquidity, lending, and confidence that is leading to ever-rising leverage and speculation. The designated-driver school says that it’s ok to get drunk once in a while – it’s part of the capitalist system, and anyway, how do you know that I’ve had too much to drink and pose a danger to myself and others? – and that the Central Bank can act as the designated driver and take the economy home safely after it is heavily intoxicated.
There are good arguments for both approaches. On the one hand, cleaning up after a huge mess can be much more expensive than averting it pre-emptively, as this crisis has led governments to accumulate significant debt through automatic stabilizers (like unemployment insurance and welfare schemes and taxes) and through discretionary measures to bail out banks, prevent foreclosures, and boost employment. Central Banks have limited power to affect the economy once the economy is in crisis and interest rates have been lowered to zero, though Bernanke and company have come up with some creative ways to restore confidence in the financial system (mainly by directly purchasing riskier assets from banks in exchange for safer ones and increasing the Central Banks balance sheet risk).
On the other hand, it may be very difficult for the Central Bank to predict when there is a bubble in the economy. Even when this is not the case and there are clear signs that stocks or commodities or home prices have departed from their long-term fundamental values, pre-emptively popping a bubble is costly as well. The Central Bank would be effectively inducing a recession during the upswing of a boom to prevent a worse one in the future – given that the current recession is definite and the future one is abstract and uncertain, it may be very difficult politically do this. Think about how hard it is for the fiscal authorities to raise taxes and cut spending during good times – the Keynesian idea of balancing aggregate demand over the business cycle is fundamentally sound, but often runs into the problem that elected governments rarely get rewarded for saving for a rainy day and always get rewarded for what they do now.
The Designated driver school
The conventional and reality-based designated driver school has current and former Federal Reserve Chairmen Alan Greenspan and Ben Bernanke as its main exemplars. They do not deny that bubbles can occur or that financial crises are costly in terms of unemployment and lost output, but argue that the Central Bank USUALLY has sufficient power to help the economy during a recession and can come up with some creative ways to help the economy even during a really bad recession where we hit the zero lower bound for interest rates. So a financial crisis is not that costly. On the flip-side, popping a bubble pre-emptively by taking away the punch bowl carries significant risks. First, it can be very difficult to identify a bubble before the fact – who knew that pets.com wouldn’t generate trillions in revenue? Some of the internet start-ups turned out to be majorly underpriced and have become major fixtures of our lives – think amazon, google, etc. Who knew that the increase in housing prices wasn’t being driven by a change in the fundamental demand for owner-occupied housing in America combined with a justified confidence in future growth prospects?
Even if we can identify a bubble before the fact, when is the right time to pop it? If you pop it too early, you may be aborting a period of solid growth that would have only culminated in a small bubble that inflicted minimal damage on the economy. If you pop it too late, you might as well have let the crisis come to a head naturally because you are not really preventing a major dislocation caused by a large swing in asset prices. It is costly to pop bubbles by raising interest rates because raising interest rates lowers lending in the economy and tends to drive up unemployment, and this is bound to be unpopular, especially when there is pain now for uncertain gain in the future. Moreover, risk in the financial sector is really up to the financial sector to manage, and it is up to elected officials to determine what (potentially costly) restrictions and regulations to implement. Better to get out of the bubble predicting business and focus on what the Central Bank does best – predict inflation and change interest rates to keep it stable, allowing prices to act as an appropriate signal for market participants.
There is also an extreme version of this view, which might be better described as the "drunk-driving" school or the "I’m not really drunk school." Not surprisingly this view finds some support among the disciples of Milton Friedman at Chicago (though it is debatable whether Friedman himself would support all of these views). This school of thought holds that (a)bubbles can’t and don’t happen and (b)unemployment and bank failures are essentially good things and are not harmful at all. Take Eugene Fama, who was recently at the top of the Bank of Sweden Prize in honor of Alfred Nobel short-list for his significant contributions to financial economics – in a recent interview with the New York Times, he claims that "I don’t know what a… bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning." Bubbles aren’t just hard to predict ex-ante – they don’t exist. Similarly, mass unemployment is always voluntary – Casey Mulligan has advocated the "Great Vacation" view of current high unemployment and John Cochrane has stated that “We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.”
This is not too far from the Ron Paulite view that eschews any type of government intervention – financial crises are caused by the government actively intervening in the economy, by regulating finance, printing money and actively managing liquidity, and through fiscal policy. I discussed and dissected this way of thinking in detail in a previous blog post. I won’t go into detail here, but essentially this view boils down to wishing we had a gold standard (so there is no longer any monetary policy), disposing of fractional reserve banking (putting us basically in a barter economy with minimal saving and lending) and ignoring the history of financial crises before there were central banks and fiat money.
There are several schools of punchbowlism, but all of them hold that part of the duty of any Central Bank is crisis prevention, and that it may sometimes be worth sacrificing some economic growth and employment in the present to prevent major negative events in the future. Given recent events it is not surprising that the pendulum of economic thought has swung somewhat in this direction, but it is unclear that any of the proposals that are now floating around will be implemented in the future.
The first school of punchbowlism is what you might call the "right-wing" school, based on the idea that the right would usually prefer a little less inflation and more unemployment while the left wants the opposite. This view does not require a radical overhall of the way the Federal Reserve conducts monetary policy – rather, the Central just has to be a bit more hawkish on inflation and has to adopt a slightly more expansive view of inflation. One of the main proponents of this view is Edward Leamer. According to Leamer, housing booms and busts have been at the center of nearly every recession after WWII. One of the problems with the way the Federal Reserve conducts monetary policy is that it targets the Consumer Price Index (CPI) as its measure of inflation. The CPI is a price index designed to capture a representative "cost of living" for the United States, based on a representative basket of consumer goods. Housing is a major component of CPI – around 40% – but the way housing prices are measured is the tricky part. Housing prices in the CPI are based on rental prices, which theoretically correspond to the implicit value of owner-occupied housing. The price of a house, the asset, should be equal to the future stream of income you could get by renting it (to yourself or someone else) at competitive market rental rates, suitably discounted. So when the authorities go and track changes in the housing price component of the CPI, they look at rental rates. The only problem is that during the latest housing bubble, housing price/rental ratios increased to historic levels – indeed, this is some of the main evidence presented by people who successfully predicted that there was a bubble in housing prices. It’s not that the Fed was unaware of this. In 2005 they wrote:
Downward pressure on rental prices mainly resulted from an increase in demand for homeownership, which was spurred by historically low mortgage interest rates (see Figure 19). As housing starts and home sales surged in the recent recession and recovery, the national rental vacancy rate jumped from 7.8 percent in the fourth quarter of 2000 to 10.2 percent in the fourth quarter of 2003. This effect was compounded by the way owner-occupied housing prices are measured in the CPI. The CPI uses a rental-equivalence approach, measuring the value of the shelter services an owner receives from his or her home. Price movements in owners’ equivalent rent reflect changes in prices of rental units that are comparable in characteristics to owner-occupied homes. Therefore, increased demand for homeownership put downward pressure not only on tenants’ rent but also on owners’ equivalent rent — the largest component in the CPI. In other words, not only were high and rapidly rising housing prices not incorporated in the CPI (and hence in the Federal Reserves decision about whether or not to raise interest rates), but they actually decreased the inflation of the housing component of the CPI.
Leamer’s solution is to take housing prices more seriously and augment the traditional monetary policy rule (called a Taylor rule), which puts some weight on deviations of inflation from the target and some weight on deviations of unemployment from the target, by adding an index of housing prices (or price to rental ratios, and their deviation from some historic norm). If the Federal Reserve had adopted this approach, it would have kept interest rates higher or raised them earlier in the middle of the 2000s, which would have moderated the run up in housing prices, stocks, and financial institution leverage – all without violating the fundamental principle that the Central Bank’s main purpose is to maintain stable prices. I think this approach definitely has some merits, but the difficulty of determining the fundamental value of assets like stocks or housing means that practically, this approach runs into some of the same problems that led Alan Greenspan and Ben Bernanke into the Designated Driver school.
A second school of punchbowlism might be called the "Fed as scolding parent" view, and is promulgated by Paul Krugman among others. This school does not criticize the actual conduct of monetary policy during the 2000s, but rather focuses on the authority and expertise of central banks and the mere effects of their pronouncements on elected officials and markets. Greenspan often stepped into the political debates of his era, taking stands on taxes and deficits that seem to be outside of the scope of the Central Banks mandate (and supposed objectivity with regards to politics, especially redistributional issues). He was also a cheerleader of the ability of markets to manage risk, as is evident in the quote in my previous post. Krugman believes that the Central Bank, as a major employer of economics expertise that wields considerable authority, should have interevened more "verbally" in the economy. When there were early signs of a housing bubble, the Central Bank should have identified it as such, alerting policy makers (who could then have regulated sub-prime, as they are doing now, implemented more consumer protections, regulated the ratings agencies, put pressure on major banks to deleverage, etc.) and also sending a warning to market participants. By identifying a bubble as such publicly and by taking a public stand in favor of sensible regulation, the Central Bank could have conceivably averted the financial crisis without ever firing a shot. At the very least, they should have tried.
A third school of punchbowlism is the one advocated by Robert Hall. Hall argues that the Central Bank has one policy lever – the interest rate – and one objective – stable and low inflation. If the Central Bank is to tackle a separate objective – crisis prevention – it needs a separate, independent policy lever. For Hall this is capital requirements, which essentially dictate to banks what their leverage can be – how much they have to keep in reserves and safe assets, and how much they can lend based on a certain amount of "safe" capital. Changing capital requirements used to be a major tool of Central Banks (along with the discount window and open market operations) but has not been used much lately. But there is no doubt that the argument has certain merits – if the main cause of the crisis is excessive leverage used for speculation and risky investments, directly targeting leverage seems like a sensible thing to do. The tricky part here is that many institutions are not subject to capital requirements – the Investment Banks like Lehman, Bear-Stearns, Goldman, etc. – and that banks have found many ways to financially innovate around these requirements, with both off-balance sheet investments as well as rating agency corruption that can make risky assets look like safe assets that satisfy capital requirements (e.g. the slicing and dicing of mortgages that somehow became AAA).
Given the difficulty of regulating financial institutions, including the major political pressure that these institutions bring to bear and their close ties to the Central Banks themselves, the "second-best" school of punchbowlism holds that sometimes, the Central Bank will just have to use a blunt instrument that it can control and wield without political pressures – the interest rate – to occasionally conduct open heart surgery. The interest rate is not always the best policy, but we certainly know that it works (and can induce recessions pretty much at will) and is insulated from the vagaries of partisan politics and big money influences. This is probably the mostlikely outcome of the current crisis, combined with some "scolding" along the lines of Krugman. In the next post I will discuss some of the proposals for regulation and reform of financial institutions and regulation, but at the moment the clearest outcome from the 2007-201? financial crisis and recession is that monetary policy authorities will be both more verbally active in identifying bubbles and leverage and a bit more inclined to raise interest rates to take some of the air out pre-emptively.