Someone Is Saying Something Wrong
on the Internet in the Pages of the Wall Street Journal!
My friend Mark Thoma is trying to diminish my quality of life by emailing me links to Donald Luskin writing in the Wall Street Journal:
Luskin: President Barack Obama proposed last month that the Fed act as an overall “systemic risk” regulator, with consolidated supervisory responsibility over “large, interconnected firms whose failure could threaten the stability of the system.” Now William C. Dudley, the ex-Goldman Sachs economist just appointed president of the New York Federal Reserve, has upped the ante.... Mr. Dudley is effectively asking for the power to control asset prices...
The Federal Reserve is not "asking for the power to control asset prices." It already has the power to control--or, rather, profoundly influence--asset prices already. When the Federal Reserve carries out an expansionary open-market operation, the whole point of the exercise is that it boosts bond and stock prices. The Federal Reserve buys bonds for cash. There are then fewer bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes up, and their yields--the interest rates quoted in the financial press--go down. Also by supply and demand, when bonds are yielding less investors are willing to pay more for substitute assets like equities and real estate, and their prices go up as well.
When the Federal Reserve carries out a contractionary open market operation, the same process works in reverse: the whole point of the exercise is that it lowers bond and stock prices. The Federal Reserve sells bonds for cash. There are then more bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes down, and their yields--the interest rates quoted in the financial press--go up. Also by supply and demand, when bonds are yielding more investors are willing to pay less for substitute assets like equities and real estate, and their prices go down as well.
For Luskin to claim that Dudley is asking for something new--that there is an extraordinary increase in the big, bad government's power to regulate financial markets contained in Dudley's "effectively asking for the power to control asset prices" is to demonstrate a degree of cluelessness that takes my breath away. The Federal Reserve already has the power to control asset prices. It has had this power since its founding in 1913. That's the point. That's what a central bank does. That's what it's for: it's an island of central planning power seated in the middle of the market economy.
If you don't like it, call for its abolition. But don't pretend that it isn't there--don't pretend that "Mr. Dudley... asking for the power to control asset prices" is some wild change in our current system.
Jeebus save us...
So what did Federal Reserve Bank of New York President William Dudley say at the 8th Annual BIS Conference in Basel last June 26?
We had not understood that interconnection had breached the firewalls of the banking system--that it was no longer enough to guarantee the stability of the financial system that the FDIC guaranteed deposits and the Federal Reserve supervised commercial banks, as we saw when the disruption of the securitization marktes of the shadow banking system quickly transmitted itself to the entire financial sector and caused the biggest globl economic decline since the Great Depression. Thus "the U.S. Treasury is right in proposing a systemic risk regulator as part of their regulatory reform plan... we shouldn’t kid ourselves about how difficult this will be to execute.... It will take the right people, with the right skill sets, operating in a system with the right culture and legal framework. I don’t believe creating this oversight process will be an easy task"...
We need to try to "engineer out of the financial system" destabilizing positive-feedback mechanisms like: (a) collateral tied to credit ratings; (b); collateral and haircuts; (c) compensation "tied to short-term revenue generation, rather than long-term profitability over the cycle"; (d) incentives for banks to fail to "raise sufficient capital to be able to withstand bad states of nature... many banks did not hold sufficient capital and market participants knew this"...
Specifically, we need to add debt that automatically converts to equity on the downside
And, specifically, we need CDOs and other securitized obligations that are easier to value, and we need more public reporting of exposures.
It's only after this that Dudley gets to monetary policy and asset bubbles, and his belief that we need "a critical reevaluation of the [Greenspanist] view that central banks cannot identify or prevent asset bubbles, they can only clean up after asset bubbles burst." There is an opportunity for the government to "lean against the wind" in real time, Dudley believes, and cites as an example that "the compressed nature of risk spreads and the increased leverage in the financial system was very well known going into 2007."
The problem with "leaning against the wind" to some degree to try to curb the growth of asset bubbles, Dudley says, is that the standard tool that the Federal Reserve uses to affect asset prices are open-market operations directed at the short end of the yield curve, and "the instrument of short-term interest rates... is not well-suited to deal with asset bubbles." The problem is that using short-term interest rates to manipulate asset prices raises or lowers all asset prices together, which means that one risks curbing the bubble by attacking the economy and causing the recession one wants to avoid. In a bubble the Federal Reserve does not want to lower all asset prices but, rather, just the prices of those risky assets that are affected by the bubble.
One way to think about it is that standard Fed tools allow it to affect the market rate of time preference and thus the level of asset prices, but that the configuration of asset prices is actually a two-dimensional animal in which both the rate of time preference and the premium on risk are important. The Fed then needs two different policy instruments to do its job. Open-market operations that affect the rate of time preference are one. And Dudley thinks that banking collateral regulatory policy--"we might give a systemic risk regulator the authority to establish overall leverage limits or collateral and collateral haircut requirements... limit leverage and more directly influence risk premia..."
But nobody should believe the Wall Street Journal when it tells us that Dudley wants to move us into a world in which for the first time the Federal Reserve "is effectively asking for the power to control asset prices." That's not what is going on at all.
Why oh why can't we have a better press corps?