The Fed and Bubbles
I don't intend this to be a big opus on the Fed and bubbles. I simply want to add my two-cents worth to what I keep hearing and, more importantly, not hearing about it on financial TV and radio.
As background, as Dallas Fed President, I served on the FOMC from February 1991 to November 2004, all that time under Alan Greenspan as Chairman. That period included the dot.com bubble and the beginning of the real-estate bubble.
There seems to be an almost unanimous consensus today that the Fed should have pricked both those bubbles early on and not have let them grow. I have heard no one mention, however, that the Fed had no mandate or legal authority to base monetary policy on bubbles.
We hear a lot these days about the Fed's dual mandate, price stability and sustainable economic growth, which were eventually distilled down from more than two. The principal one dropped along the way was balance in international payments, which came to be perceived as either automatic or irrelevant under floating exchange rates. With the exchange rate free to adjust, policy didn't have to.
In the old days-especially in the days of Texas populists on the House Banking Committee-the Fed was burdened greatly by a Congressional tug-of-war over its goals of price stability on the one hand and rapid growth and full employment on the other hand. Miraculously, there finally came a time when a critical mass of economists and politicians accepted the proposition that in the long run there was no real conflict between the two. The conflict was resolved by the acceptance or toleration of the proposition that price stability provided the best economic environment for sustainable growth. So, while both goals were important, price stability was both an ultimate goal and a precondition for the other ultimate goal.
At no time during these debates that I'm aware of was preventing or pricking bubbles considered a legitimate central bank goal. More importantly, it was not part of the Fed's mandate as set forth in the Federal Reserve Act, the Employment Act of 1946, or Humphrey-Hawkins. There was, and is, no legal basis for the Fed to make bubble busting an independent goal of monetary policy.
There was a general consensus among FOMC members in the late 1990s that the stock market boom was difficult to understand, especially after it continued strongly after the Chairman's Irrational Exuberance speech in 1996. Staff presentations generally had a correction somewhere in the future because they just couldn't rationalize the skyrocketing of the stock market, especially dot.com stocks. I don't recall the term "bubble" being used much, but that's neither here nor there.
What I do recall was Chairman Greenspan asking more than once during committee discussions something like "Who are we to put our judgment of appropriate stock prices ahead of millions of individual investors?" This sentiment was not expressed in the context of a debate on whether we should do something about stock prices. There was no such debate, although the subject of possible changes in margin requirements came up from time to time. The Chairman dismissed that on the grounds that they wouldn't be effective, that they would hurt small investors while large, more sophisticated, investors would find a way around them.
I remember very well my own thoughts on the subject. I imagined, if we were to tighten monetary policy to curb rising equity prices, what the announcement would have sounded like and what the public reaction would have been. I imagined a press release along the following lines:
"The FOMC met today [some day in the late 1990s], reviewed economic and financial conditions, and established policy for the coming period. Economic growth appeared strong, but sustainable, employment growth was robust, unemployment remained low, and inflation was continuing to moderate. In summary, the economy is performing better than it has in decades.
Despite good growth and low inflation, however, the committee concluded that monetary policy should be tightened because of the recent overly-rapid rise in equity prices. To curb the rise in the equity prices, the Committee decided to raise its target Federal funds rate by 50 basis points. The Committee also expressed its commitment to continue to monitor the situation closely and to stand ready to take further actions as necessary to bring rapid stock-price increases under control. It is the intention of the Committee to prevent a stock market bubble from forming."
How do you think that announcement would have been received, by the public, and by Congress?
When I retired in November 2004, Chairman Greenspan, as I recall, was still declining to use the word "bubble" to describe the then national real estate market. There may have been a few localized bubbles, but no national bubble. He thought "froth" might better describe the national situation while acknowledging that froth could be defined as many little bubbles.
But, "froth" versus "bubbles" was beside the point. The Fed had no mandate or legal authority to use monetary policy to limit house-price appreciation even if it had wanted to. It would only do so as part of a more generalized overheating of the economy that threatened an acceleration of inflation.
I was at the Jackson Hole meeting when Chairman Greenspan made his famous bubble speech-about how you really can't tell it's a bubble before it bursts, and how it's the job of the central bank to clean up afterward. This was after the dot.com bubble burst, but before the real-estate bubble had formed.
I found that to be a strange speech with a strange conclusion-not that I necessarily disagreed with its conclusion, but because I didn't know what purpose it served. Leaving aside the minor issues of no mandate from Congress and no legal authority, since it was made after the dot.com bubble burst, I doubt that he convinced his audience. It had the opposite effect on me, and I think the Chairman would have been better served not to bring it up.
The real-estate bubble needed some air let out before it popped, but if Congress wants the Fed to have bubble-popping responsibility in the future, it should say so. It should pass a law. (Did I say that?)
I don't necessarily agree that the Fed should have such a mandate, but, if we are going to hold it responsible for bubbles, Congress should say so before, rather than after, they pop. And, by the way, the legislation should include instructions on how to recognize them on Friday morning rather than Monday morning.
“The Fed had no mandate or legal authority to use monetary policy to limit house-price appreciation even if it had wanted to. It would only do so as part of a more generalized overheating of the economy that threatened an acceleration of inflation.”
Did it ever occur to anyone at the Fed that skyrocketing house prices themselves are a form of inflation?
Or is it true what they say: That wage inflation is the only kind the Fed actually cares about?
It seems to me that the bulk of the current pain is being caused by the liquidation or whatever you want to call it of AIG and Lehman which does not have as much to do with subprime as with CDS market and leverage. As a regulator of banks one can hardly escape blaming the Fed for a portion of that but they didn’t regulate brokers and the guys who thought they could operate at 30 to 50x leverage are far more to blame…But Greenspan is also adding to the current meme that it was that evil capitalism that caused all this….what is he thinking? Do you think capitalism is to blame? or might it just maybe somehow be a failure of the regulatory apparatus? Nobody is saying that and it is soooo obvious.
If I recall correctly, Milton Friedman expressed his desire for a system where the money supply was allowed to increase at a steady pace. This system would eliminate the need for targeting the Fed Funds rate, and would really diminish the power of the FOMC Chairman. I believe Friedman wasn’t comfortable with the ability of a person to make the calls that the Fed Chairman is forced to make though he believed Greenspan was extremely good at his job.
I’ve always wondered what someone who had been a party to these important monetary decisions thought about the viability of such a plan. My personal opinion is that price stability is of paramount importance, and a system that minimized the human aspects (i.e. political pressure, personal leanings, etc.) would be a net benefit. However, human intervention would probably still be necessary during crises that require a quick decision to provide varying levels of liquidity.
I posted this on Krugman’s blog. I don’t know if you consider it fair:
I believe that regulation should be minimal, and work. Greenspan said today:
“It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today’s markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime.”
That’s what I’ve always believed. If you allow a crisis, it’s much worse than minimal regulation. Here I agree with Keynes, there’s no good reason for it.
By minimal, to the extent that I understand them, I would include CDO’s and CDS’s. Anything meant to shift risk, in other words, needs to be looked at. I’m not saying always regulated, but looked at to make sure the system is transparent and collateralized. I keep hearing about risk. If you try to shift it to others or expect the government to cover you, it makes it easier to risk.
As to the Fed, I think that Greenspan willfully ignored problems, but I’m not a fan of the spigot theory, which says that if interest rates are too low or there’s too much capital around, you’ll end up with a bubble. Politically, if people are making money and feeling secure, however foolish they are in feeling that way, raising interest rates to spoil the party on a theory will be hard.He should have slowed the economy to check the engine, but a lot of people kept telling him to drive.
The sad thing is that, I know I could be wrong, the things that we needed to do, like a clearinghouse for swaps and Greenspan slowing the economy a bit to get us to check the engine, would not have been that hard or onerous to the market.
— Posted by Don the libertarian Democrat
Hi Bob,
Won’t the bursting of an asset price bubble not lead to deterioration in long-term employment? So it becomes part of the Fed’s mandate.
On price stability – why don’t we include asset prices in the calculation of inflation? Stable prices are good for long-term prosperity – why should it only include consumption prices and not investment prices?
Gaurav
I would say that “bubbles” are predominantly a form of inflation from too loose monetary policy and that if the Fed wanted it could consider it a part of their mandate already without Congressional action.
The Fed’s view on bubbles helped fuel what became known as “the Greenspan put” — the conviction among investors that the Fed would let them take excessive risks and step in as custodian if the bets they made went awry. By giving market participants an incentive to assume greater risk than they would have otherwise, the Fed’s laissez-faire position on bubbles may have contributed to the surge in credit that helped push housing inflation skyward in the first half of this decade.
Despite Greenspan’s defenses, there are quite a few signs the Fed should look for when attempting to identify asset bubbles, in order to reduce the risk of implosion. Consider these 10 elements to identifying bubbles in the equity markets in real time that the Fed, or anyone else for that matter, can use:
1. Standard Deviations of Valuation: Look for traditional metrics — P/E, price to sales, etc. — to rise two, then three standard deviations away from the historical mean.
2. Significantly elevated returns: The S&P500 returns in the 1990s were far beyond what one could reasonably expect. Consider the years around Greenspan’s “Irrational Exuberance” speech:
1995 37.58
1996 22.96
1997 33.36
1998 28.58
1999 21.04
And the Nasdaq numbers were even better.
3. Excess leverage: Every great financial crisis has at its root easy money and rampant speculation. Find the leverage, and speculation wont be too far behind.
4. New financial products: This is not a sufficient condition for bubble, but it seems that every major bubble has somewhere in the mix, new products. It may be Index funds, derivatives, tulips, 2/28 Arms.
5. Expansion of Credit: With lots of money floating around, we eventually get around to funding the public. From Credit cards to HELOCs, the 20th century was when the public was invited to leverage up also.
6. Trading Volumes Spike: We saw it in equities, we saw it in derivatives, and we’ve seen it in houses: The transaction volumes in every major boom and bust, by definition, rise dramatically.
7. Perverse Incentives: Where you have unaligned incentives between corporate employees and shareholders, you get perverse results — like 300 mortgage companies blowing themselves up.
8. Tortured rationalizations: Look for absurd explanations for the new paradigm: Price to Clicks ratio, aggregating eyeballs, Dow 36,000.
9. Unintended Consequences: All legislation has unexpected and unwanted side effects. What recent (or not so recent) laws may have created an unexpected and bizarre result?
10. Employment trends: A big increase in a given field — real estate brokers, day traders, etc. — may be a clue as to a developing bubble.
While we can debate whether or not the Fed should intervene by popping bubbles, we can all agree that, at the very least, they should not contribute to bubble inflation . . .
When you say price stability, I assume you mean stability of the CPI. If that is the case, then the current measure of CPI, or even the basis for using CPI as the gauge of price stability is clearly inadeqaute.
I have no idea what is included in the CPI, but shouldn’t asset prices (be it real estate, or stock prices) be included with an appropriate weighting.
Also, could you explain why most countries do not publish how they calculate CPI?
Even though the Fed isn’t mandated to prick bubbles, isn’t it mandated to maintain financial stability? When bank balance sheets were becoming highly leveraged and stuffed with loans to highly valued real estate market, I would have thought that that would pose a systemic risk to the banking system, which might require fed action, but then, I have the benefit of hindsight…
Bob, I have truly become a fan of your Blog.Thank You for your insight.I could not agree with you more.Unfortunately though where our gov’t (Politicians) is concerned they tend to drive looking at the past rather than forward toward the future.I have always suspected it is because the past is a known vs the unknown so why stick your neck out.In addition taking a position requires you to defend and explain it ,it is much easier to play both sides,if it is good take credit if it is bad go after the bad guys and take credit…so much for courage…..Speaking of which One of our greatest economic minds was taken to task this weak…My hat is off to you Dr Greenspan your 40 year old eco model appeard to be flawed…maybe not totally in my opinion,however it took great courage for a man in his eighties to testify before congress and admit that maybe he missed something…I wonder if some of those doing the questioning could show as much character.
Do you not think that the Fed has some responsibility to reign in "easy credit" when it is pretty obvious the loans are not to credit worthy home borrowers? Or at least warn about lack of down payments on home loans or in the 1990s impose higher stock margins? And how about keeping the dollar a stable currency? Or how about money supply growth averaging above 6% annual growth, on average, over the last 10 years. A look back at 1929 or 1989-1990 in Japan could have told one that consumer price inflation in not always a good sign of "easy credit"- that sometimes it shows up as asset bubbles.
First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mathematically “precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;
Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.
The lags for monetary flows (MVt), i.e. proxies for (1) real GDP and the (2) deflator are exact, unvarying – respectively. Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).
Not surprisingly, adjusted member commercial bank “free/gratis” legal reserves (their roc’s) corroborate/mirror, both lags for monetary flows (MVt) –– their lengths, or frequency, are identical — (as the weighted arithmetic average of reserve ratios remains fairly constant)
The lags for both monetary flows (MVt) & “free/gratis” legal reserves are indistinguishable. Consequently it has been mathematically impossible to miss an economic forecast (bubble, etc.).
There are no inaccuracies, just some non-conforming & unavailable data (e.g., revisions have been overlaid & lost, flawed deposit classification, data discontinued, etc.). This is the “Holy Grail” & it is inviolate & sacrosanct.
The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.
Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.
Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points.
In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
Some people prefer the devil theory of inflation: “It’s all Peak Oil’s fault.” This approach ignores the fact that the evidence of inflation is represented by “actual” prices in the marketplace. The “administered” prices of the world’s oil producing countries would not be the “asked” prices were they not “validated” by (MVt), i.e., validated by the world’s Central Banks ( i.e., as Friedman maintained “inflation is always and everywhere a monetary phenomenon”)
Eric, you are doing a great scrivee here. Believe me, there are many folks who talk the talk around here, who have little idea about how these basics (that you are generously covering) actually work.If there’s anything Americans need, especially the investor class, it’s a little remedial refresher. By the way, it was good to see the M3 explained in your 2005 balance sheet. I believe it was May 2006 when that criminal Greenspan outlawed that knowledge for the first time in 93 years. And, that’s when things got really ugly and we global traders hedged against the long-term viability of the United States. The CNBC zombies, not so much…Follow your instincts and keep doing what you are doing. It’s powerful stuff.(Ditto on another commentor’s remarks on PayPal. Check your set-up.)