links for 2009-06-30
Les Flaneurs vs. the Philosophers

Please Allow Me to Introduce Myself: I'm a Central Banker of Wealth and Taste...

Now other people are weighing in. Here are a bunch of smart reactions to my "Sympathy for Greenspan" piece.

First, some scene-setting:

Knut Wicksell some eighty years ago argued that the purpose of a central bank like the Federal Reserve is to manipulate the money stock so that the "market" rate of interest is equal to the "natural" rate of interest. The natural rate of interest is the rate of interest at which intended savings is equal to intended investment--at which the rewards to saving call forth enough abstinence from consumption on the part of households to equal business desires to try to make additional profits by expanding capacity.

Why have the central bank manipulate the money stock? After all, won't the market eventually get it right? Wicksell said that the key was the "eventually": if the money stock was too low then the market rate of interest would be above the natural rate, and you would have a prolonged period of unanticipated deflation (because demand for consumption and investment goods together would be below the value of production, which is equal to households' incomes) that would cause lots of unemployment until the price level had fallen enough to make desired money holdings low enough to reduce the market rate to the natural rate; if the money stock was too low then the market rate of interest would be below the natural rate, and you would have a prolonged period of inflation (because demand for consumption and investment goods together would exceed the value of production, which is equal to households' incomes) that would cause lots of unjust wealth redistributions until the price level had risen enough to make desired money holdings high enough to increase the market rate to the natural rate. Better to aid the market in its job via activist central-bank monetary policy.

Thus Wicksell gave economists and central bankers:

  • a goal for monetary policy: to set the market rate of interest equal to the natural rate.
  • a rationale for monetary policy: to quickly carry out the adjustments to the real money stock that the unaided laissez-faire market would carry out only slowly and painfully.
  • a way to judge the central bank: it was doing its job of setting the market to the natural rate if there was neither unanticipated inflation--which would mean the market rate was too low--or unanticipated deflation--which would mean the market rate was too high.

You can think of Wicksell's insights this way: In a credit economy the market interest rate would always be equal to the natural interest rate that balances desired saving and desired investment. However, we live not in a credit but in a monetary economy in which the interest rate has to both balance supply and demand for investment and balance desired increases in people's cash holdings to the increase in the money supply. It cannot do both of those--not and keep full employment--unless the increase in the money supply is of exactly the right magnitude. The job of the Federal Reserve is thus to change us back so that even though we live in a monetary policy interest rates are as if we lived in a credit economy.

That was what Alan Greenspan was trying to do in the first half of the 2000s: to set the market rate of interest equal to the natural rate. And he succeeded: there was neither unexpected inflation nor unexpected deflation.

But was it a mistake for Greenspan to have carried out the mission that Knut Wicksell assigned him? Should he have pushed the market rate of interest above the natural rate--pushed investment, production, and employment below their credit-economy laissez-faire levels--in the interest of avoiding the growth of a housing bubble?

I don't know: But other people are willing to venture an opinion:

Mark Thoma:

Economist's View: I have argued the Fed's decision to keep interest rates low contributed to the bubble, but was not itself the sole cause of it. As to whether the Fed made a mistake, I'll just note that the tradeoff wasn't quite as stark as Brad implies, i.e. there were other policy instruments that Fed could have used to limit the housing bubble. Regulation is certainly one means the Fed had to that end, but Fed communication could have helped too. If Greenspan had, for example, told people to stay away from mortgages because they were toxic rather than implicitly encouraging them to invest in housing, things might have been different.

Would limiting the bubble through regulation, communication, or other means have limited the employment response, the primary worry? I don't think so, at least not enough to matter. The money would have been invested somewhere, housing had an opportunity cost after all, so the next best alternatives would have been pursued to the extent that they were profitable (and many would have been, just not as profitable - apparently anyway - as investing in housing and mortgages). So people still would have been employed somewhere as the money was invested, just not in housing, and that would have helped to insulate us from the housing crash. (And a lot of them might still have those jobs, unlike the people who depended upon the housing markets for employment.)

So narrowly, keeping interest rates low and employment high was the right thing to do. The mistake was letting all of the action brought about by those low rates, or most of it anyway, occur in a single sector, housing, rather than using regulation and other means to limit the flow of resources into the housing market in pursuit of profits based upon the misperception of risk. Those resources could have been redirected into other sectors and put to productive use rather than wasted building houses nobody wants, and achieving this result did not require the Fed to aggressively raise the target rate, it only needed to use the other tools it already had available.

Unfortunately, however, those tools were not used, and the ideology Greenspan brought to the Fed played a large role in this outcome.

Michael @ Bright Rights:

Bright Rights: The causes of the financial crisis: Brad Delong has a nice post outlining some of the mistakes the government made before or during the crisis. I agree with all of the three points listed at the beginning of his article, but I disagree with his comment on Greenspan's involvement. Brad DeLong states:

On Tuesdays and Thursdays I think that going forward central bankers must now also recognize that it is imprudent to lower interest rates in pursuit of full employment when doing so risks an asset price bubble. On Mondays, Wednesdays, and Fridays I think that even with the extra information about the structure of the economy we have learned in the past two years that Greenspan's decisions in 2001-2004 were prudent and committed us to a favorable and acceptable bet. And I am writing this on a Friday.

I think before explaining my point of view, let me explain something about Alan Greenspan. Alan Greenspan believed (I don't know if he still holds this view) that central bankers should not involve themselves in asset bubbles. According to Mr. Greenspan, it is too difficult to identify when something is actually a bubble, until after it blows up. I think this is an incredibly irresponsible opinion. But I think if you are going to take the view, as Brad DeLong does at the end of his post, that Greenspan's actions were reasonable at the time, you have to take into account how Greenspan would react if he lost this bet. If an asset bubble occurs, in my opinion a central banker needs to step in and try to deflate it before it creates a crisis. However, Greenspan didn't believe in deflating bubbles; he believed in dealing with them after they blew up. Taking this view into account, it seems unreasonable to me to say Greenspan's actions were correct. I think they were only correct if he would have been willing to deflate bubbles. But we know he wasn't.

David Beckworth:

Macro and Other Market Musings: Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake: Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s: not accelerating inflation but rather deflation threatened. The natural interest rate was very low because, as Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). You can argue--and on Tuesdays and Thursdays I will believe you--that Alan Greenspan's policies in the early 2000s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity.... [A] rise in productivity growth should lead to a rise in the natural interest rate and ultimately, a rise in the federal funds rate for monetary policy to stay neutral. However, this latter development did not happen. It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria. This interpretation of events has been borne out more rigorously in this ECB paper. One a more practical level, this disequilbria comes through in the Taylor rule which similarly shows the federal funds rate was below the neutral rate during this time.

It is also worth noting that these same rapid productivity gains were the source of the deflationary pressures in 2003 that Brad mentions. Thus, these deflationary pressures did not indicate a weakening economy. In fact, aggregated demand (AD) was growing at at rapid rate in 2003-2004 which, if anything, indicated an overheating economy. The figure below shows a measure of AD, final sales to domestic purchasers, relative to the federal funds rate and has the period 2003-2004 marked off by the dotted lines (click on picture to enlarge):

The productivity gains, apparently, were offsetting the upward pressure on prices being created by the robust growth in AD at this time. There simply was no real deflationary threat in 2003. By way of contrast, this figure shows for 2008-2009 what a real AD-induced deflationary threat looks like. Regarding the saving glut theory I would recommend Menzie Chinn's post here or my previous post here...

Greg Ip:

What the regulators did wrong | Free exchange | BRAD DELONG catalogues the consensus on three mistakes the Fed made leading up to and during this crisis, and also gives a balanced and anguished analysis of a fourth: whether Alan Greenspan erred in keeping interest rates as low as he did.

I agree with almost everything here, in particular that it was almost impossible at the time to believe the Fed was erring in holding rates too low. (If the error was so obvious, surely more people would have pointed it out at the time, even if not a majority of people, right?) That this does not look the right decision in hindsight is because the small risk of a catastrophic financial collapse was in fact realised.

Where I do disagree, however, is his faulting abandoment of principles-based regulation, which he says allowed the shadow banking system to grow as much as it did beyond the reach of regulation. In fact, the decision to let the shadow banking system grow as large as it did was a textbook example of principles-based regulation. In most of the markets that went awry, bank regulators ran the show, and in America bank regulation is principles-based.

Regulators pride themselves on closely monitoring banks' behaviour, often from inside the banks themselves. If they get worried, they quietly tap the bankers on the shoulder and suggest they do something differently. When troubles arise, they are often handled with a nonpublic order. And when an order becomes public it is devoid of useful information, such as what the bank did wrong.

Contrast this with the SEC, which is rules-based and will make an errant broker take a perp walk in front of the TV cameras as a lesson to his peers. This different approach is precisely why, during the 2008 debate about financial modernisation, people like Hal Scott wanted a single financial regulator to adopt the approach of the bank regulators rather than that of the SEC.

This principals-based approach can be very powerful: regulators can bar a merger, ban a banker or do any number of far-reaching things. But the fact of the matter is that the bank regulators choose which principles to live by. They had countless opportunities to rein in the shadow banking system and chose not to because the most important principle guiding their action was to safeguard the depository. The Fed oversaw bank-holding companies and in theory had oversight of the off-balance sheet and non-bank activities that got banks into trouble. It chose not to exercise that oversight as long as the rest of the entity was a “source of strength” to the depository. Regulators also did not force banks to keep full capital on hand for off-balance-sheet vehicles, because to do so would've frustrated the very purpose of them: to legally segregate risky assets from the depository. In both these instances bank regulators used a principals-based approach. They simply deprioritised the principles that would prove most important. They failed to look for potential sources of systemic risk and think creatively about how things that should not have threatened the bank in theory did in practice.

This is a cautionary tale to those who call for principles-based regulation. Just how it works in practice depends on the principles being observed.

Noam Scheiber:

Are We Too Hard On Greenspan? (Hint: Probably Not.) - The Stash: I guess my problem with this analysis is that I don't think it's right to lump the years 2001-2004 together. From early 2001 to early 2003, the economy was indeed very weak, and it's hard to quibble with Greenspan's decision to ease interest rates aggressively and stay easy. But by mid-2003, the economy was growing at a decent clip. It may not have been quite at full employment, but certainly stable. And yet Greenspan lowered the fed funds rate another quarter point to an eye-popping 1 percent in June of 2003, and kept it there through June of 2004. (And though the tightening began at that point, the fed funds rate was still at a mere 2.25 percent through January of 2005.) During the four quarters between June '03 and June '04, the economy grew at a real rate of 7.5 percent, 2.7 percent, 3 percent, and 3.5 percent. So when people talk about a monetary policy mistake, I think they're generally refering to that final year of easing, not the 2001 through mid-2003 period.

The stated reason for this continued easing was that Greenspan wanted to take out an insurance policy against deflation, of which there were some mild hints at the time, though even Greenspan referred to them as remote. In retrospect, this concern was probably unwarranted, as inflation chugged along either at or well-above the Fed's implicit target through all of 2004. Worse, all the easing appears to have resulted in a massive real estate bubble.

But, as DeLong says, the question isn't whether a policymaker is wrong in retrospect. The question is whether he or she made a reasonable bet at the time. DeLong thinks maybe. I lean the other way. Here's why: DeLong's defense of Greenspan hinges on the idea that, if it turned out the Fed was wrong about the necessity of easing--so wrong it created a bubble that later popped and threatened a deflationary spiral--the Fed had enough powerful tools at its disposal to prevent a depression at that point.