Interesting speech from the seminar "Disruptions to Financial Systems, and Challenges to Regulation and Supervision" from the First International Research Conference of the Reserve Bank of India, by William White, Chairman of the Economic and Development Review Committee of the OECD: http://www.24framesdigital.com/rbi/webcast/120210/session3/william_white.html.
Do central banks have a role in leaning against the development of credit bubbles?
1) is it possible? He says the Fed uses "asset prices" as a proxy for credit. Don't lean against asset prices, lean against credit bubbles. If there's a credit problem it manifests itself as an imbalance, which shows up either in asset prices, crazy spending patterns, or crazy investment patterns. Can you lean against those things? He thinks bankers can.
Is it too difficult to identify when you have a problem? At the current moment, we don't really know about aggregate demand, aggregate supply; and yet we have to unwind huge stimulus packages. So anything that indicates (from an analytical point of view) that we don't have a problem is highly suspect; and in that case, it shouldn't be hard to spot a credit bubble.
2) Is it possible to clean up after a bubble bursts? At 3:50, he says: "The argument that the Fed uses is that it's always worked in the past."
His claim is that in 1987, 91, 97, 98, 2001-3, the Fed's lowering interest rates is pushing the problem into an asset price bubble via a "headwind of debt"; push the problem under the rug but don't actually solve it. After a while you trip on the gigantic bump in the rug.
In his words, "it works for a while, but it doesn't work forever." "The economy works differently than we've been taught." "The models are worth nothing..." because the economy is not self-stabilizing.
"Stocks and imbalances are the crux of the matter"
He claims additionally (in effect) that there's excessive supply, and that some of the government stimulus packages that don't help wind down supply are not sustainable: cash-for-clunkers, short term jobs for car workers in Germany, China holding the RMB low to sustain exporters.
Williams was speaking in response to a speech by Stephen Roach of Morgan Stanley Asia. Roach says:
1) The Fed has had a negative real federal funds rate for half the time since 2000. "If you say the fed policy is fine, you're also saying that it's fine for the world's most powerful central back to run the most stimulative and accommodative policy in real terms since the 1970s." He adds "this is not a great and comforting comparison".
2) He worries about the asymmetrical reactions of the Fed and other central banks: very quick to cut rates at a disruption, slow to raise them again. The slow increasing is based on "weak recoveries, low and anchored inflationary expectations" etc. This slow response plays a critical role in establishing the "daisy chain" from bubble to bubble. It's also grounded in the analytical models used by the Fed, and it's due to studying what Japan did after their bubble burst. The Fed doesn't try to burst bubbles; it tries to clean up the mess after the bubble bursts of its own accord.
His suggested policy response:
1) In a crisis, it's appropriate to take emergency responses. But when the emergency is over, don't continue the stimulus. If you don't have a good recovery, so be it. Don't keep the Fed rate below zero (real), but bring it up to zero (in real terms).
2) We missed the crisis because of too narrow a view of financial instability's ability to distort the real economy and the cross-border linkages. When asset markets got away, major sectors of asset-dependent economies were distorted. If someone says, "You can't use monetary policy to deal with asset bubbles, it's too blunt an instrument," Roach replies, "when you have an economy like the United States where bubble-distorted consumption and homebuilding activity … at the peak rose to 80% of GDP, you want a blunt instrument."
3) The way to break the daisy chain is for Central Banks to have an explicit financial stability mandate. In 1946, Congress mandated full employment; in the late 1970s, they added price stability; it's time to add financial stability to the mandate.
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