Alan Meltzer on Fed mistakes and Issing on Jackson Hole Strategy

Otmar Issing in his paperpresented at BIS takes you through monetary policy history, move from Bundesbank to ECB and ECB’s 2 pillar strategy and the need to focus on money.  It is a pretty comprehensive paper and only likes of Otmar can say so much in such few words.

He also writes on the buring issue foir central banks- should central bank target asset prices? (Pretty longish but worth reading)

On the role of asset prices there is wide consensus on the following principles:(1) Central Banks should not target asset prices;
(2) Central banks should not try to prick a bubble;
(3) Central banks should follow a “mop up strategy” after the burst of a bubble which means injecting enough liquidity to avoid a macroeconomic meltdown.

(1) and (2) are uncontroversial. A central bank has no instruments to target successfully asset prices and creating a macroeconomic disaster by pricking a bubble would ruin the standing of a central bnk. (The role of a central bank as a regulator and supervisor is a separate issue.) On (3) there is also broad agreement – once a bubble has burst the central bank has to take all necessary steps to avoid the propagation of the consequences of a collapse of asset prices.

However, restricting the role of the central bank to a totally passive role in the period of the built-up of a bubble and practically pre-announcing its role as the “saviour” once the bubble bursts represents an asymmetric approach which might imply the risk of creating moral hazard with actors driving the development of asset prices.

What can be called the “Jackson Hole Consensus” (Greenspan (2002); Blinder (2005); Mishkin (2007)) is exactly that. Efficient markets incorporate all relevant information and reflect the markets best assessment. How could a central bank pretend to know better? “ The `mop up after` strategy received a severe real world stress test in 2000-2002, when the biggest bubble in history imploded, vaporizing some $8  trillion  in wealth in the process.

At a closer look the “Jackson Hole Consensus” raises further questions. Even if the mop up strategy might work initially, by exactly doing “its job” in a financial crisis of limited dimension, because of its asymmetric character it may lay the ground for the next bubble and crisis (and so on).

The asymmetry in this monetary policy proposal is strengthened by the practice of what has been called “risk management” paradigm. This can be seen as an approach to deal with low probability events and severe outcomes against which a kind of “insurance” (eg via interest rate cuts) has to be applied (Greenspan (2004)). It seems that this approach so far has only been referred to or applied in dealing with risks of recession or deflation, that is, in a rather asymmetric way.

The greatest macroeconomic risk is apparently a broad collapse of asset prices (including real estate) after a big bubble, destroying balance sheets of banks and other financial institutions, non-financial companies and households. If such a disaster emerges mop up is without alternative but is anything than a fast working and satisfying solution.Should not risk management also be applied by looking forward and trying to if not avoid at least mitigating the risk of the built- up of a bubble that sooner or later might burst?

This leads to the argument of the central bank leaning against the wind. This is anything but a simple device and it is not even certain that it might always work sufficiently well. But, this is no argument to let things just go, keep central bank interests low even if the economy is doing well.

Can central banks under such circumstances just ignore the impact of low central bank interest rates on the financial industry, on innovations, decline in spreads across different types of risk etc. and on asset prices especially for housing? There is evidence that (too) low interest rates eg encourage too much risk taking by banks with the consequence of threatening financial stability (ECB (2007)). 

I have been a big fan of Jackson Hole Conferenceorganised by Kansas Fed each year. The sheer quality of papers is simply amazing. However, it is being targeted quite a bit in this crisis. Raghu Rajan had warned of the incentive problems in 2005 conference but was ignored (read this WSJ Blog post). Krugman occasionally takes a dig at economists who simply said things to please Greenspan at Jackson Hole Conference. I had pointedto a detailed article on Bernanke where BIS economists complaint that they were ignored in same conference for raising asset price concerns. And now this take by Otmar Issing, who is one of the all time best monetary economists around.

Broadly, Rodrik is absolutely right when he says what matters is the predominance of a particular idea which then leads to similar policies. Now if there is a idea backed by all time great central banker it needs a crisis like this to shackle the beliefs.

Alan Meltzer (a noted economic historian who has done tons of research on Fed) comments on the Issing paper. He just slams Fed:

For me the most striking difference between euro policy and dollar policy comes in the role of politics. The Maastricht treaty gave much greater independence to the central bank than the Federal Reserve experiences.

Through most of its postwar history, the Federal Reserve accommodated Congressional and administration concerns to a much greater extent than the European Central Bank. It kept the long-term interest rate fixed until March 1951 despite rising concerns about inflation. In the 1960s, it “coordinated” policy with the administration. Chairman Martin often explained that the Federal Reserve was “independent within the government.”

The current Federal Reserve seems spineless. Under pressure from Congress and the financial markets, it abandoned its balanced medium-term strategy to give priority to avoiding possible recession. Its short-term forecast was wrong. Growth is slow, but the often predicted deep recession has not come. Instead we have a return of inflation and a loss of credibility and independence. In March, the Fed began to lend on relatively illiquid mortgages in exchange for Treasury bills. It abandoned its long-standing policy of avoiding lending on relatively illiquid assets. Previous exceptions had always been for small amounts. Two days after the Chairman of the Banking Committee and some other Senators proposed  yhat the Fed lend on student loans, Chairman Bernanke announced that it would.

This is really nasty. His take on asset prices and mon policy:

For years, Karl Brunner and I struggled with models in which asset prices and credit markets have a large role. Credit market behaviour and asset price changes are parts of monetary analysis that most models ignore. (I should except the BIS from that statement.) I agree with Issing that this is a failure of the models that becomes most important at times of rapidly rising asset prices. What to do?

The first problem is to decide whether asset price changes are a response to real forces or expected inflation. This is not an easy calculation to make, but once it is made the central bank’s response seems obvious. The calculation is difficult because so called bubbles can best be labelled as such after they end. Much of the theory of bubbles developed in models where there are no transactions. Prices rise because everyone expects them to rise.

The rise in stock prices in the late 1990s differed. Some sold the securities that eager buyers bought. The sellers must have had different expectations. Furthermore not all security prices did rise rapidly. Much of the rise occurred in assets believed to benefit from new technology, an expected technological change that the central bank can only prevent by imposing its judgment. This does not seem defensible to me. However, if the analysis of a model with asset prices implies that inflation will follow, the central bank should act on that knowledge.

The second recent surge in asset prices came from the housing sector. The Federal Reserve erred. It predicted deflation and overstated the effects of a small deflation. It remains a puzzle for me why one would expect deflation in an economy with a depreciating currency and a relatively large budget deficit. My work on the Federal Reserve history suggests that there were seven deflations in Federal Reserve history, some as large as a 20 percent decline. Only one, the Great Depression, was a disaster. It differed from the others mainly because money growth fell more than the price level and continued to fall until 1933. ctation of continued deflation was correct in 1929-32.

The history of deflation has been covered extensively in this superb Bordo and Filardo paper. They divide deflations into good, bad and ugly. The ugly ones are quite rare and Meltzer also says the same. Further:

The Federal Reserve’s error did not require markets to invest in low quality assets. That was their error abetted by two other errors. One is the Basel Accord that requires increases in reserves if banks increase risky assets. The banks followed the first law of regulation: Lawyers write regulations but bankers circumvent costly regulations. Lawyers ignore the incentives implied in new regulation. The second error is the incentives faced by market participants. Why did the MBA alumni of the world’s leading business schools buy and sell first dot-com securities and later low quality mortgages? The compensation system rewards them and their supervisors for doing just that. Failure to participate may bring satisfaction later but most likely from the unemployment queue.

One must always recall that financial markets lend long and borrow short. Crises will occur,  but a better compensation scheme and greater concern for the incentives induced by regulations can reduce the risk inherent in financial markets.

Having completed a lengthy history of the Federal Reserve’s achievements and errors during almost 75 years, I feel compelled to add a bit about error. The Federal Reserve and others made many errors. It pains me to recognise that most of them were widely believed and advocated by academic economists. Examples are the real bills doctrine, fiscal and monetary  policy coordination, cost-push inflation, the reliability of the Phillips curve, and the dismissal of excess monetary growth as a cause of inflation.

Great stuff from Issing and Meltzer. Must read for those interested in monetary economics. Both stress on the need to stick to basics of monetary policy but also point that something has to be done about asset prices.

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3 Responses to “Alan Meltzer on Fed mistakes and Issing on Jackson Hole Strategy”

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