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2016-10-20 14:22:16
Oct 19th 2016, 14:56 by R.A. | WASHINGTON
I HAVE not yet had an opportunity to read Sebastian Mallaby s new biography of Alan Greenspan (pictured), The Man Who Knew. I have heard great things about it; you can read Martin Wolf s review of the book in The Economist here. (Full disclosure: Mr Mallaby is a former Economist journalist and is married to our editor-in-chief, Zanny Minton Beddoes.) In reading coverage of the book, I have been intrigued by one of Mr Mallaby s judgments of Mr Greenspan: that he was insufficiently committed to keeping control of asset prices. Mr Wolf quotes the book as follows:
The tragedy of Greenspan s tenure is that he did not pursue his fear of finance far enough: he decided that targeting inflation was seductively easy, whereas targeting asset prices was hard; he did not like to confront the climate of opinion, which was willing to grant that central banks had a duty to fight inflation, but not that they should vaporise citizens savings by forcing down asset prices. It was a tragedy that grew out of the mix of qualities that had defined Greenspan throughout his public life intellectual honesty on the one hand, a reluctance to act forcefully on the other.
In an interview with Greg Ip (another former Economist journalist; they re everywhere), Mr Mallaby says more:
What I discovered in my five years of research was that the Fed tried more than we realised to do things about subprime mortgages, about Fannie and Freddie, the GSE lenders. The New York Fed tried a bit on excess leverage at the banks. And these regulatory efforts were stymied by the fact that the U.S. regulatory system is extremely balkanised, very political, and it s extremely hard to really drive down risk through regulation. Therefore, I think, the real mistake was not to push with interest rates.
This, it seems to me, is wrong. There are many aspects of Mr Greenspan s career deserving of criticism, but his decision to give up on the attempt to steer the economy by manipulating asset prices was one of his better judgments. Using interest rate increases to try to bring down asset prices would be a very bad idea.
Why? To begin with, central banks mission to keep inflation under wraps is not drawn from thin air. Rather, their aim is to stabilise demand growth. Working out how best to do that has been the subject of decades of intellectual debate within economics, leading to the majority view (if not the consensus) that targeting a low but positive rate of inflation provides a balance of costs and benefits as good as or better than alternative policy targets. The economic ideas underpinning this approach could be wrong, but economists do have a reasonable idea how it all is supposed to work.
We do not, by contrast, have a good understanding how targeting asset prices might lead to more stable demand growth. I understand the sentiment behind Mr Mallaby s argument: when big bubbles deflate it is very painful, therefore reining in potentially dangerous asset-price growth should be helpful to the economy. Unfortunately, things are not so simple. Which asset prices should we worry about? What is the right level for those prices? How do we expect reduced asset prices to propagate through the economy: what will happen to the outlook for inflation (and therefore to real interest rates) or to the demand for cash? How will broader expectations adjust? Can the policy of pre-emptive bubble popping survive the Lucas critique; that is, is the way Mr Mallaby thinks the policy should work invariant to people realising that asset prices have become a policy target? This stuff is really important! Before inducing a major recession in order to shrink household wealth dramatically, one should have a pretty good
idea what step two is going to be. A few economists like Jeremy Stein, for example have made tentative steps toward incorporating financial stability variables into a normal monetary-policy framework: but they have been very tentative steps indeed and quite recent.
Another problem: it is not clear that step one would do what Mr Mallaby would like it to do. He tells Mr Ip that a repricing of assets can occur without a massive economic dislocation, pointing to the taper tantrum of 2013, when Fed officials began discussing plans to bring quantitative easing to an end, leading to a surge in Treasury yields. [T]he Fed did effect a repricing of asset market, and the amount of tightening needed was 0%, Mr Mallaby says. This seems like an odd example, however. The spike in yields proved short-lived; Treasuries now yield less than they did before the tantrum, even though the Fed has tightened policy substantially, by bringing QE to an end and raising the short-term interest rate.
Neither is that the only recent example. In the 2000s, the Fed did ultimately move to tighten monetary policy significantly, increasing the federal funds rate by four full percentage points between 2004 and 2006. The effect on mortgage rates, however, was somewhat smaller than anticipated (see chart).
Housing prices did begin falling in 2006, calamitously. Yet that decline seems more closely linked to tumbling growth in demand, as captured in growth in nominal output. Both NGDP growth and housing-price growth began a sharp deceleration in 2006. That leads to an important question: how much of the pain of the Great Recession was a necessary consequence of the unwinding of the housing bubble, and how much was the result of a dramatic decline in demand which both worsened the housing crash and which would have been a necessary component of any earlier attempt to reduce housing prices by raising interest rates? What Mr Mallaby is arguing for, remember, is more tightening earlier in the 2000s. But we saw what a large dose of tightening accomplished from 2004-6. Prior to 2004 the American economy was struggling through a jobless recovery, flirting with deflation: hardly an ideal environment in which to raise interest rates substantially.
The right conclusion to draw from the experience of the 2000s is not that Mr Greenspan showed poor judgment and weakness in failing to punish American households with more rate hikes. The right conclusion to draw is that Mr Greenspan s options were constrained by global macroeconomic dynamics that were poorly understood at the time, and to which he responded about as well as could be expected. The financialisation of the global economy has clearly affected the operation of monetary policy. The interest rate that matters now is the global real interest rate, and national central bankers face constraints in setting domestic monetary policy as a result. As a result of those constraints, central bankers cannot easily raise long-term borrowing costs, since efforts to tighten policy attract capital inflows. Weak demand is a chronic condition in this world, outside of circumstances in which asset prices are growing rapidly or government borrowing is used to prop up demand. It is somewhat extraordinary that in the
wake of the crises of the last decade we are more open to the idea that growth should be slower, and slumps deeper and more frequent, than to entertaining the possibility that the benefits of free capital flows might not be worth the macroeconomic costs, and that governments should bear greater responsibility for stabilising demand. If Mr Greenspan s career teaches us anything, it is that we should not expect too much of our monetary maestros.