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| Source: Wall Street Journal |
Interest rates make the headlines, but the Federal Reserve's most important role is going to be the gargantuan systemic financial regulator. The really big question is whether and how the Fed will pursue a "macroprudential" policy. This is the emerging notion that central banks should intensively monitor the whole financial system and actively intervene in a broad range of markets toward a wide range of goals including financial and economic stability.
For example, the Fed is urged to spot developing "bubbles," "speculative excesses" and "overheated" markets, and then stop them—as Fed Governor Sarah Bloom Raskin explained in a speech last month, by "restraining financial institutions from excessively extending credit." How? "Some of the significant regulatory tools for addressing asset bubbles—both those in widespread use and those on the frontier of regulatory thought—are capital regulation, liquidity regulation, regulation of margins and haircuts in securities funding transactions, and restrictions on credit underwriting."
This is not traditional regulation—stable, predictable rules that financial institutions live by to reduce the chance and severity of financial crises. It is active, discretionary micromanagement of the whole financial system. A firm's managers may follow all the rules but still be told how to conduct their business, whenever the Fed thinks the firm's customers are contributing to booms or busts the Fed disapproves of.
Macroprudential policy explicitly mixes the Fed's macroeconomic and financial stability roles. Interest-rate policy will be used to manipulate a broad array of asset prices, and financial regulation will be used to stimulate or cool the economy.
Foreign central banks are at it already, and a growing consensus among international policy types has left the Fed's relatively muted discussions behind. The sweeping agenda laid out in "Macroprudential Policy: An Organizing Framework," a March 2011 International Monetary Fund paper, is a case in point.
"The monitoring of systemic risks by macroprudential policy should be comprehensive," the IMF paper explains. "It should cover all potential sources of such risk no matter where they reside." Chillingly, policy "should be able to encompass all important providers of credit, liquidity, and maturity transformation regardless of their legal form, as well as individual systemically important institutions and financial market infrastructures."
What could possibly go wrong?
It's easy enough to point out that central banks don't have a great track record of diagnosing what they later considered "bubbles" and "systemic" risks. The Fed didn't act on the tech bubble of the 1990s or the real-estate bubble of the last decade. European bank regulators didn't notice that sovereign debts might pose a problem. Also, during the housing boom, regulators pressured banks to lend in depressed areas and to less creditworthy customers. That didn't pan out so well.
More deeply, the hard-won lessons of monetary policy apply with even greater force to the "macroprudential" project.
First lesson: Humility. Fine-tuning a poorly understood system goes quickly awry. The science of "bubble" management is, so far, imaginary.
Consider the idea that low interest rates spark asset-price "bubbles." Standard economics denies this connection; the level of interest rates and risk premiums are separate phenomena. Historically, risk premiums have been high in recessions, when interest rates have been low.
One needs to imagine a litany of "frictions," induced by institutional imperfections or current regulations, to connect the two. Fed Governor Jeremy Stein gave a thoughtful speech in February about how such frictions might work, but admitting our lack of real knowledge deeper than academic cocktail-party speculation.
Based on this much understanding, is the Fed ready to manage bubbles by varying interest rates? Mr. Stein thinks so, arguing that "in an environment of significant uncertainty . . . standards of evidence should be calibrated accordingly," i.e., down. The Fed, he says, "should not wait for "decisive proof of market overheating." He wants "greater overlap in the goals of monetary policy and regulation." The history of fine-tuning disagrees. And once the Fed understands market imperfections, perhaps it should work to remove them, not exploit them for price manipulation.
Second lesson: Follow rules. Monetary policy works a lot better when it is transparent, predictable and keeps to well-established traditions and limitations, than if the Fed shoots from the hip following the passions of the day. The economy does not react mechanically to policy but feeds on expectations and moral hazards. The Fed sneezed that bond buying might not last forever and markets swooned. As it comes to examine every market and targets every single asset price, the Fed can induce wild instability as markets guess the next anti-bubble decree.
Third lesson: Limited power is the price of political independence. Once the Fed manipulates prices and credit flows throughout the financial system, it will be whipsawed by interest groups and their representatives.
How will home builders react if the Fed decides their investments are bubbly and restricts their credit? How will bankers who followed all the rules feel when the Fed decrees their actions a "systemic" threat? How will financial entrepreneurs in the shadow banking system, peer-to-peer lending innovators, etc., feel when the Fed quashes their efforts to compete with banks?
Will not all of these people call their lobbyists, congressmen and administration contacts, and demand change? Will not people who profit from Fed interventions do the same? Willy-nilly financial dirigisme will inevitably lead to politicization, cronyism, a sclerotic, uncompetitive financial system and political oversight. Meanwhile, increasing moral hazard and a greater conflagration are sure to follow when the Fed misdiagnoses the next crisis.
The U.S. experienced a financial crisis just a few years ago. Doesn't the country need the Fed to stop another one? Yes, but not this way. Instead, we need a robust financial system that can tolerate "bubbles" without causing "systemic" crises. Sharply limiting run-prone, short-term debt is a much easier project than defining, diagnosing and stopping "bubbles." [For more, see this previous post] That project is a hopeless quest, dripping with the unanticipated consequences of all grandiose planning schemes.
In the current debate over who will be the next Fed chair, we should not look for a soothsayer who will clairvoyantly spot trouble brewing, and then direct the tiniest details of financial flows. Rather, we need a human who can foresee the future no better than you and I, who will build a robust financial system as a regulator with predictable and limited powers.
*****
Bonus extras. A few of many delicious paragraphs cut for space.
Do not count on the Fed to voluntarily limit its bubble-popping, crisis management, or regulator discretion. Vast new powers come at an institutionally convenient moment. It’s increasingly obvious how powerless conventional monetary policy is. Four and a half percent of the population stopped working between 2008 and 2010, and the ratio has not budged since. GDP fell seven and a half percent below “potential,” in 2009 and is still six points below. Two trillion didn’t dent the thing, and surely another two wouldn’t make a difference either. How delicious, in the name of “systemic stability,” to just step in and tell the darn banks what to do, and be important again!
Ben Bernanke on macroprudential policy:
For example, a traditional microprudential examination might find that an individual financial institution is relying heavily on short-term wholesale funding, which may or may not induce a supervisory response. The implications of that finding for the stability of the broader system, however, cannot be determined without knowing what is happening outside that particular firm. Are other, similar financial firms also highly reliant on short-term funding? If so, are the sources of short-term funding heavily concentrated? Is the market for short-term funding likely to be stable in a period of high uncertainty, or is it vulnerable to runs? If short-term funding were suddenly to become unavailable, how would the borrowing firms react--for example, would they be forced into a fire sale of assets, which itself could be destabilizing, or would they cease to provide funding or critical services for other financial actors? Finally, what implications would these developments have for the broader economy? ...As if in our lifetimes anyone will have precise answers to questions like these. In case you didn't get the warning,
... And the remedies that might emerge from such an analysis could well be more far-reaching and more structural in nature than simply requiring a few firms to modify their funding patterns.A big thank you to my editor at WSJ, Howard Dickman, who did more than the usual pruning of prose and asking tough questions.
So we can entrust nuclear weapons to our government but not banking?
ReplyDeleteYou can thank the Jacksonian Democrats for that one:
Deletehttp://en.wikipedia.org/wiki/Bank_War
The government has not actually used (as opposed to tested) nukes since 1945. If the point of a capacity is that its threat ensures it will never have to be used, perhaps we can more readily trust the government with it. That self-fulfilling aspect is dubbed the "Chuck Norris effect" by Nick Rowe. He was referring to a central bank credibly committing to increasing aggregate demand/NGDP/inflation. I don't know if its regulatory powers would work similarly, I'd have to hear some specific proposals.
DeleteHuh? This is about the silliest analogy I have ever heard of. Banking: directing a large, decentralized market with thousands of participants each having local information and strong incentives, including incentives to lobby. Nuclear weapons: They sit in silos until launched. Governments can, do and should run armies!
DeleteWhile private actors have local information, only the government has as much information about the systemic structure and consequences. It would seem an inefficient waste not to act on that systemic information to prevent harm and to promote stability. An engineer cannot optimize a system while ignoring systemic consequences.
DeleteLimited power is orthogonal to political independence. Political power comes from achieving political objectives. The Federal Reserve's credibility comes from demonstrating objectivity, competence, and fairness. Even if one interest group disliked a Fed action, that interest group would not necessarily have sufficient clout to alter the established tradition of central bank independence nor would the interest group necessarily have a viable alternative it would prefer. Fortunately for sustaining central bank independence and stability, the Fed has independent incentives, independent funding, and diffuse institutional decision-making process.
Whether the marginal harm of uncertainty is greater than the marginal benefit of action offers a principle that could lend stability to markets and credibility to the Federal Reserve. Following this rule, proper policy will seek to reduce fundamental volatility. Any additional innovations resulting from Fed action would be compensated for by its helping the economy to avoid systemic crises, and over time volatility arbitrageurs will dampen residual noise.
Of course, with great Fed power comes great responsibility and let us hope macro prudence.
Hi Lewis,
Delete/While private actors have local information, only the government has as much information about the systemic structure and consequences.
And yet in many cases short sellers have been more effective than the SEC at finding accounting fraud.
/It would seem an inefficient waste not to act on that systemic information to prevent harm and to promote stability. An engineer cannot optimize a system while ignoring systemic consequences.
Communists thought decentralized planning was inefficient for a similar reason. Certainly finding and removing dangerous or inefficient incentives is important, but it seems more often than not these incentives come from regulations (which were set up to “fix” something), not the market. As Hayek pointed out "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." The men and women in the Fed are still men and women.
/Political power comes from achieving political objectives.
I might have spent too much time in China, but I thought political power grew out of the barrel of a gun. (Though that might be what you mean.)
/Whether the marginal harm of uncertainty is greater than the marginal benefit of action offers a principle that could lend stability to markets and credibility to the Federal Reserve.
It seems that this article is trying to point out that increasing the Fed's regulatory purview creates more uncertainty.
“Willy-nilly financial dirigisme will inevitably lead to politicization, cronyism, a sclerotic, uncompetitive financial system and political oversight. Meanwhile, increasing moral hazard and a greater conflagration are sure to follow when the Fed misdiagnoses the next crisis.”
/proper policy will seek to reduce fundamental volatility.
Which might suggest reducing uncertainty, which would imply the Fed following rules, so that its actions could be predicted, rather than having a more discretionary (and therefore a more unpredictable) scope.
-Ed
Paul Volcker, a guy I really like, authored a terrible piece in the NY Review of Books advocating the Fed shed its noisome dual mandate (employment and price stability) to focus on fighting inflation, popping bubbles and souped up financial regulation.
ReplyDeleteIn short, the Fed would have no accountability or responsibility for economic growth.
1. What is a bubble? EMT anyone? If the Fed starts popping bubbles preemptively, what will that do to general economic growth?
2. Central banks are public agencies. Fighting inflation is easy. With only little accountability to the public, and no mandate to encourage economic growth, one easily envisions a cloistered, inbred Fed exultant in its triumph over inflation (oh, and economic growth? Not my job.)
3. Volcker argues we have amish-mash on federal regulatory agencies, easily manipulated by the industry and poorly organized. That is right. Should the Fed assume regulatory powers/ Tough call.
Benjamin,
Delete"What is a bubble?"
Probably not the technically correct definition but let's start with the value of an asset. What are the components of value:
1. Production value - I buy a good because I can use it in the production of other goods
2. Utilitarian value - I buy a good because I can use it to serve a basic need (food, shelter, etc.)
3. Luxury / Ephemeral value - I buy a good because I feel better about myself in owning that good
4. Market value - I buy a good because I believe I can resell it at a profit
In short, a bubble occurs when the market value of an asset exceeds other measures of the value of the same asset. Can the Fed assign dollar figures to each value metric for every asset out there? No they can't. The only thing they can do is monitor the the market value of the the assets and the debt associated with them.
"Central banks are public agencies. Fighting inflation is easy."
Fighting inflation means producing more goods than are demanded. The central bank does not produce goods.
"Sharply limiting run-prone, short-term debt is a much easier project than defining, diagnosing and stopping bubbles."
ReplyDeleteThere is only one way you limit run-prone, short term debt - make the cost of borrowing long term less than the cost of borrowing short term. Which means either:
Federal reserve pushes short term interest rates above long term interest rates OR
Federal government lowers after tax cost of borrowing long term.
Fiddling with the rates for short and long term debt is not the only way, or a very effective way, of limiting the amount of short term debt. Much the best way is to simply make it illegal for banks to fund themselves out of short term debt. Personally I’d make it illegal for any bank to fund itself using debt of any sort.
DeleteAs George Selgin put it in his book “The Theory of Free Banking”, “For a balance sheet without debt liabilities, insolvency is ruled out”. I.e. if bank departments / subsidiaries or other entities that lend out money are funded only by shareholders or quasi-shareholders, those departments or entities cannot suddenly collapse.
In contrast there are bank departments / subsidiaries / other entities which run checking or transaction accounts. Those can perfectly well accept deposits (i.e. have short term liabilities), but they should be barred from investing in anything other than monetary base or short term government debt. That way, they cannot suddenly go bust either.
Matthew Klein explains how this would work in this Bloomberg article:
http://www.bloomberg.com/news/2013-03-27/the-best-way-to-save-banking-is-to-kill-it.html
Ralph,
Delete"Fiddling with the rates for short and long term debt is not the only way, or a very effective way, of limiting the amount of short term debt."
I was speaking to short term debt across all sectors (business, banking, and government). The race to borrow at the shortest maturity began with Bill Clinton's Treasury Department and continued through Bush's.
"...if bank departments / subsidiaries or other entities that lend out money are funded only by shareholders or quasi-shareholders, those departments or entities cannot suddenly collapse..."
They cannot go bankrupt. However, they can become unprofitable rendering the equity worthless.
"Those can perfectly well accept deposits (i.e. have short term liabilities), but they should be barred from investing in anything other than monetary base or short term government debt."
Like I said, I was speaking to short term debt across all sectors (public and private).
Here is a question that I asked Matthew and never received a response:
And would these lending companies be required to submit bids on U. S. Treasury issuance (ala the primary dealers)?
Since we are separating lending companies from the Federal Reserve system, it may not be profitable or in the best interest of the share holders for them to lend to the federal government.
If I am a shareholder of a lending company, why would I ever lend to the federal government?
Frank,
DeleteUnder Laurence Kotlikoff’s system (which I like), the “lending companies” (or mutual funds as they would be under Kotlikoff’s system) would specialise in different forms of lending and investment. No doubt some would specialise in lending to government.
Ralph,
Delete"No doubt some would specialize in lending to government."
Yes, doubt that any would voluntarily specialize in lending to government. Without access to short term funding courtesy of the central bank, the required return on investment for a profit seeking company investing in government bonds gets very large.
Mutual funds tend to be pass through vehicles set up by large financial institutions. Mutual funds do not make lending decisions, they buy loans made by banks.
Under Mr. Kotlikoff's system - who makes the lending decision?
1. The equity / shareholder concerned solely about profitability?
2. The mutual fund investor that works an 8:00 to 5:00 job?
Interesting comment about trusting the government with nuclear weapons but not banking. Of course a sane government would understand that use of nuclear weapons would end government, as we know it.
ReplyDeleteBetter then to control all aspects of a citizen's life and keep the thumb of oppression always on the scale.
Riddle this: In a world, where a keystroke can impose stringent anti-despotic financial sanctions, would America prefer such influence be held by an All-Powerful Federal Reserve? Or, would America prefer such influence be held, by a less than All-Powerful Federal Reserve?
ReplyDeleteAn additional riddle-bit: In a world, where a keystroke can impose stringent politically motivated sanctions, would Libertarians prefer such influence be held ...
It may be Grumpy, that every form of refuge, indeed, has its price.
"The science of "bubble" management is, so far, imaginary."
ReplyDeleteThis is the best sentence of this post. Couldn't we go farther, though, and say: "The science of "economics" is, so far, imaginary."
Banks should be required to have stable structures - you just disagree about the mechanism, not the principle.
ReplyDeleteWe currently have the world's biggest ever bubble in the derivatives markets and I don't see anyone doing anything to try to force an unwind of that bubble so that it does not destroy the global banking system.
No, I like stable structures, little direction. The macro prudential project keeps fragile structures -- gives up on controlling bank risk taking, bank systemic danger, or the run prone nature of bank liabilities -- and tries to control prices so the banks don't lose money in the first place.
DeleteWhat bubble in derivatives? I'm glad you know, and hope your hedge fund is short so you make a killing. But if so, you have proved my point. None of the Fed, IMF or ECB's aspiring financial system managers has breathed a peep about your bubble, so if it exists, it is once more proof that these institutions cannot diagnose and target such dragons ahead of time.
"What bubble in derivatives?"
DeleteThe one where there are swaps of risks on $700 Trillion dollars purporting to manage risks on a $60 Trillion global economy. (And yes I know that the $700 Trillion is the "notional" value being the reference principal amount - the amounts are still disproportionate to the underlying economy.)
The third lesson is the only one you really need here. It's understandable that "international macro types" should be interested in setting up new macroprudential regulatory designs. I see your point about too much discretion, but the specific problem here isn't really the discretion, but that we are giving it to the Fed, an organization largely governed by the banks themselves. So long as the Fed is not a regulator, the goals of the Fed and of the private banks it works with/for are aligned. However, this also means that the Fed will surely fail to provide any meaningful restraint on private banks' excess.
ReplyDeleteThe SEC and FDIC are supposed to be banks' adversaries, preventing them from doing stupid things that threaten the financial system. The Fed's main role is simply as a banking clearing house--processing transfers between banks. Other than that, the only business the Fed should be doing is providing liquidity, as needed.
Prof Cochrane,
ReplyDeleteUntil recently I would have thought that all economists, left, right and center would have agreed with this statement of yours: "Monetary policy works a lot better when it is transparent, predictable and keeps to well-established traditions and limitations, than if the Fed shoots from the hip following the passions of the day."
But then I read of a prominent economist who took the opposite view, arguing "[I]nstitutions do the work of rules, and monetary rules should be avoided...Unless it can be demonstrated that the political institutional route to low inflation -- to commitment that preserves the discretion to deal with unexpected contingencies and multiple equilibria -- is undesirable or cannot work, I don't see any case at all for monetary rules."
When I read that quote, I thought to myself, yikes! I'm glad that this person is probably just an obscure academic who won't actually have a role in policymaking. After all, what could be worse than a Federal Reserve board that is so intelletually bankrupt that they cannot identify an optimal monetary policy stabilization policy, articulate it, and stick to it?
And then I realized that the source of that quote is none other than Larry Summers.
Ugh.
Source: http://esoltas.blogspot.com/2013/07/what-larry-summers-said-in-1991.html
Well, "dealing with multiple equilibria" sure looks like an ambitious task for a Fed chair, requiring truly oracular perspective. But I'm awfully glad nobody blogs about whatever I was saying in 1991.
DeleteHa, that's a fair point.
DeleteOn the other hand, when someone is being considered to be the chairperson of the world's most powerful central bank, and that person's most recent public statements on monetary policy date back to 1991, its fair to scrutinze the old statements. Especially when that old evidence includes a repudiation of the very notion of monetary policy rules.
Isn't rules-based monetary policy considered best practice? At least, until recently?
Also, isn't it kind of a red flag that our future fed chief hasn't published anything significant about monetary policy in more than two decades?
This system is becoming the abstract equivalent of another system.
ReplyDeleteHint: Dirigisme
here is another clue:
Capitalism is ideally based on the principle of equality under the law, meaning that social privilege does not afford any class any economic or legal advantages (like protected classes - artfldgr) . Therefore, ideally, there should not be social classes, only economic classes.
Also rejecting this were the communists: "the doctrine of class collaboration urges them to accept inequality as part of the natural state of things and preserve the social order". (even if the order is created by the state for volkish (völkische) protected classes - artfldgr)
Only one claimed to be "third way" and did not reject protected classes (class collaboration) and even favored it as a way to unify them against a common internal enemy in exchange for power to grant more favors, which included the power of the protected class to compel.
Last time social justice was part of the landscape, it was Father Coughlin that was preaching it.
At what point do we cross the Rubicon and are no longer what we were?
never? no matter how distorted or nationalized everything is?
"equality before the law" was never about "inequality before the law for equal outcomes"
why bring it up?
because if you study this other stuff that rides aside economics, you may notice that as each lower level idea failed to bring about this forced equality, they wanted to control more higher and higher up and in more and more areas.
all justified by this idea that we can balance on a razor blade
and each time we don't balance on the edge of a razor blade, there is this play for more and more control over things so that rather than actually understand something, we seem to be letting them chase down and try to stomp on some facet that "but for it" would have allowed success.
on one side you have the Mustang feral horse. Wild, free, unpredictable, full of energy and covers a wide range in living
on the other side, you have a plow horse. its not wild and free, it never acts up, its penned up and controlled.
whats the difference?
one is driven by another entity to its goals
bubbles are caused by the state attempting to drive economy forward faster or out of order than how it wants to go. the key needed is time. why? because time lets the system play the game at all due to the games name. hot potato. up until the event happens, a bubble is a nice way to make a lot of money. each are playing hot potato.
rather than effort go into actual economically useful things. the effort instead goes into how to invent means to keep the game going for a while longer and not be stuck with the potato. the idea of putting some bad mortgages with a lot of good and everyone eating some of it was one way of attempting to make the crap go down.
what we had was a mustang
eventually the horse will be dead, and THEN they will have finally made it stable, and completely predictable - then what?
"bubbles are caused by the state attempting to drive economy forward faster ..."
DeleteThat is not the general historical experience. It may be that the so-called Bush tax cuts and the deficit spending on two wars contributed to the American housing bubble. The Fed bailing out the markets after the LTCM hedge fund blew up might have made some small contribution to the dot com bubble but it seems more likely that dot com was just another example of over enthusiasm for new technology (see canals, railroads, electricity generation, car manufacturing, etc.)
John Cochrane,
ReplyDeleteDid you happen to see this:
http://economicsone.com/
"Say no to Macro-Prudential fine tuning"
"...the central bank would also vary capital requirements cyclically, requiring financial institutions to increase their capital ratio during booms and relax them during slumps."
John Taylor's response is thus:
"But the evidence that monetary policy cannot contain excesses without inflicting severe damage is questionable. Many cite the 2003-2005 housing boom."
First, the "housing boom" began in 1997. See:
http://research.stlouisfed.org/fred2/series/SPCS10RSA
Second, the point of capital ratios is to limit the amount of debt a bank (or bank like entity) takes on.
http://research.stlouisfed.org/fred2/series/TCMDODFS
That bubble began after World War II.
Hello All members, have the power to set prices as industry creators. Some just trade according to the existing return rate. They make up a significant allowance of the quantity being exchanged in the finance economics marketplace.
ReplyDeleteThanks.
Brian Hoshowski
Question: how can the Fed predict bubbles but the market can't? How does the Fed know what is an actual bubble and what isn't a bubble but just a rise in prices?
ReplyDeleteEven if we assume that the Fed is smarter than the market, they're just a collection of very smart economists. I'd argue that there are equally smart and specialized economists outside the Fed. Those economists outside the Fed haven't been able to predict bubbles either.
Those who are lucky enough to predict collapses (I know many people point to guys like Roubini) have one data point under their belt and nothing more.
So really, who came up with this idea that the Fed can predict bubbles? It's lunacy.