The Fed Makes A Bid

Policymakers like to make particular kinds of statements at a “low attention” moment, e.g., right before a holiday weekend.  This gets items onto the public record but ensures they do not get too much attention. And if you are asked about these substantive issues down the road, you can always say, “we told you this already, so it’s not now news” – usually this keeps things off the front page.

Released on July 3rd (a federal holiday), and buried inside the Washington Post on Saturday (p.A12): An important speech (from June 26th) by the New York Fed’s controversial President, William C. Dudley.

If the Fed is to become the system or any kind of “macroprudential” regulator, what would it do with that responsibility?  This is a hot topic for Capitol Hill in coming weeks as various committees take on this topic in whole or part.

Dudley says that the Fed can pop or prevent asset bubbles from developing.  This would represent a major change in the nature of American (and G7) central banking.  It’s a huge statement – throwing the Greenspan years out of the door, without ceremony.

It’s also an attractive idea.  But how will the Fed actually implement?  Senior Fed officials in 2007 and 2008 were quite clear that there is no technology that would allow them to “sniff” bubbles accurately – and this was in the face of a housing bubble that, in retrospect, Dudley says was obvious.

Dudley is quiet on whether or not, for example, we have an emergent bubble in emerging markets today.  Is there also an effective bubble in US Treasuries, as John Campbell has argued persuasively?

“Asset bubbles may not be that hard to identify,” Dudley argues.  Fine, but it would help to know exactly the Fed would do this ex ante – not using the rear view mirror.

Of course, if the Fed can’t get better at spotting bubbles, the implication is that no one can.  Which means that “macroprudential regulator” is just a slogan – a nice piece of what Lenin liked to call “agitprop”.

And if macroprudentially regulating is an illusion, what does that imply?  There will be bubbles and there will be busts.  Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are – or are perceived to be – “too big to fail”?

You cannot stop the tide and you cannot prevent financial crises.  But you can limit the cost of those crises if your biggest players are small enough to fail.

By Simon Johnson

30 thoughts on “The Fed Makes A Bid

  1. I like your link to King Canute – another man who clearly had exaggerated notions of his own importance.
    The notion that the Fed will set out to manage monetary policy to avoid bubbles seems suspect on two counts.
    First the chairman is a political appointee and second the tools available are so blunt that the unintended consequences may be more scary than the perceived risk from an emergent bubble.

  2. One man’s “bubble” is another man’s “misspecified fundamentals”; that is, if the market is overvalued by one yardstock, taking into account additional factors can justify the market price. Dudley’s claim that assets bubbles may not be hard to identify implies that he feels he “knows” which model (or set of models) can be relied upon to justify asset prices. That’s a testable proposition, but I haven’t seen the evidence to back it up.

    There’s two other problems with his argument. The first is that monetary policy is just a single instrument, but different markets may or may not have bubbles. So which market should the Fed try to keep bubble-free? Housing? Stocks? bonds? the dollar? Adjusting monetary policy to pop a bubble in one will have implications for the others. It’s not clear how to trade these off.

    The second problem is the political one. Popping bubbles requires the central bank to take a position in markets that directly confronts speculators. There’s a long history of this in foreign exchange markets. It shows that popping bubbles is not always straightforward (but Simon knows more about this than I do.)

  3. Here’s what he says

    “If one means by monetary policy the instrument of short-term interest rates, then I agree that monetary policy is not well-suited to deal with asset bubbles.”

    I agree:

    Quite frankly, since the Fed has to use a blunt instrument, I would imagine that it would be a laggard in dealing with the problem, waiting until everybody else has attempted to deal with it, before they apply the breaks to those not involved in the bubble area as well. This reliance on the Fed seems ill-founded.

    In other words, using interest rates, the Fed will be a Leaner of Last Resort, just as it is a Lender of Last Resort.

    Dudley says this:

    “Let’s take the housing bubble as an example. Housing prices rose far faster than income. As a result, underwriting standards deteriorated. If regulators had forced mortgage originators to tighten up their standards or had forced the originators and securities issuers to keep “skin in the game”, I think the housing bubble might not have been so big.”

    I agree, except that I don’t see the need for the Fed to be the main actor against bubbles:

    My argument was that there were other, more concentrated, means of bursting the housing bubble without having to use the Fed. While you were freeing capital from housing,that might well have been better spent, you could well have been destroying other businesses with higher interest rates. If you see that it’s a housing bubble, then you should be able to deal with it as a problem of the housing sector. I’m not even sure why you believe that the Fed has the sagacity to notice the bubble, but can’t bring the problem to the attention of regulators and lawmakers, and suggest that they deal with it as a problem with the housing sector.

    Let me give you a particular proposal: As housing prices go up relative to other goods, and, hence, become More Expensive, you raise the down-payment requirement. Would that have had any effect? You are indeed reigning in a part of the economy, but it’s a particular part of the economy, as opposed to the whole economy

    Some of these same issues came up here:

  4. In retrospect it’s easy to see that what was going on in housing was bad. During the crisis some were sounding the alarm. However, it is hard to believe that any political organization will have the real strength of character to go against the tide when ‘smart money’ is funneling into anything that looks bubble like. And unfortunately, if they are right and save us from ourselves – it would probably end up looking like they over-reacted, reducing their ability to intervene the next time.

  5. “Housing prices rose far faster than income”.

    By so this measure, Dudley thinks he can detect a bubble, does he?

    Except that construction cost in the Bush years rose even faster than housing prices, and in tight housing markets where there is economic growth and substantial housing demand, the replacement cost of housing has a huge impact on housing prices.

    So I think it is reasonable to question whether the last decades run up in housing prices was a result solely of inflationary policies by the Fed, and the huge expansion of subprime lending facilitated by Fannie and Freddie, and Wall Streets’ fraudulent derivatives.

    Perhaps there were other factors at work like:

    • Restrictive housing policies in many of the most desirable metropolitan areas that drove up land costs and development costs, slowed development to a crawl and greatly increased the risk of development.

    • Restrictive environmental permitting policies that drove large building materials manufacturers to expand overseas rather than in the US, which affected those industries ability to respond economically to future increased demand, which in turn eventually drove construction materials costs skyward.

    • The huge increased demand from overseas, where in the five years prior to the collapse the world economy doubled.

    I’m astounded that so many economists across the political spectrum keep thinking that we can go back easily to historical ratios of housing prices to income, when the cost of building a house has substantially increased relative to income. The old ratios ain’t gonna come back easily, even in this near depression. There are too many regulatory impediments to go back to the good ol’ days of home building. And Cap N’ Tax will only make the cost of housing much more expensive than it is now.

  6. It is not hard to spot a bubble. Those with the power to act (mostly the Fed) were both intellectually incompetent and politically subservient to the dominant political party from 2001-2006.

    Many, many, many, many people were calling it a bubble a long time ago. Only the 1970s and 1980s Chicago elite kept defending it (Greenspan, Mankiw, even Bernanke for a long time) as non-bubblicious. The rest of us, unfortunately, have had the sense that we’re living in a bubble for 4 years, but we placed way too much faith in our “best and brightest” who denied its existence.

    Prior to this recent crisis, Paul Samuelson has argued that every major US expansion died an unnatural death at the hands of an active Fed. The recent Fed, under Greenspan and Bernanke, became sickly complacent due to a belief in perfectly efficient markets.

    read Paul Samuelson’s recent comments on this crisis here:

    Note the many times that Paul Samuelson takes Greg Mankiw out behind the whipping shed….

    “…an economist with a facile pen isn’t necessarily an overnight expert on the likelihoods in our inexact science.”


    “In one of Greg Mankiw’s articles, he said that maybe when the interest rate gets down to zero and it’s threatening to be negative, you should give a subsidy with it. Well, that’s what fiscal policy is!”


    “The 1980s trained macroeconomics — like Greg Mankiw and Ben Bernanke and so forth — became a very complacent group, very ill adapted to meet with a completely unpredictable and new situation, such as we’ve had. I looked up — and by the way, most of these guys are MIT trained; Princeton to MIT or Harvard to MIT — Mankiw’s bestseller, both the macro book and his introductory textbook, I went through the index to look for liquidity trap. It wasn’t there!”

    It remains a serious mystery why, exactly, the Fed failed to act. And what this implies for future regulatory capability. SJ argues that we cannot avoid bubbles because we cannot depend on decent regulators – our best hope is thus to keep banks small enough to fail.

    And yet, for 60+ years we did avoid serious bubbles…

    What was different about the last 8 years?

    We could blame the political system, which _repeatedly_ re-elected Presidents (Reagan, Bush II) vowed fiscal responsibility while spending lavishly to support debt-led growth. We could blame free trade, and failure to enforce our own domestic labor an environmental protections on imported goods. We could blame perverse financial instruments and opacity. We could blame deregulation. Strong dollar and excessive faith in currency markets. Corrupt banks and CEOs… bad incentives.

    We could blame all of these. But at the root of all of this stands one man, and one philosophy – and that is Milton Friedman, and the Chicago School Friedmanomicons. All of these evils ultimately harken back to a single philosophy (Friedmanomics) that had good intentions, but was carried way too far by political and economic agents who benefits from the policy outcomes.

    I’m utterly astounded to find someone of Paul Sameulson’s stature both issuing a mea culpa, AND publicly unloading on the sad state of the up-and-coming economic “scholars”. Samuelson is the guy who wrote THE textbook, not the ideological monetarist-goggled imitation that Mankiw now publishes.

    As a product of MIT, I’m also somewhat ashamed of that institution’s role in this mess.

  7. If bubbles occur as a result of an illusion/delusion that otherwise known risks are not present in a market then I would say a remedy would be to continually reinforce to each “player” that risks are always present and make sure that those risks are understood.

    Looking back were the risks being denied, glossed over, hidden or outright masked and disguised? Also, did any moral hazards and bad incentives exist and contribute to the bubbles?

    So … perhaps a good place to start would be to make a better effort to make the risks understood and to remove the bad incentives and moral hazard.

  8. Everybody benefits from and loves a bubble when it is expanding. What regulator will want to take heat from his political bosses for inflicting what seems like wholly unnecessary pain on merely the prospect of some speculative future harm? To expect regulation to stop bubbles is to expect what has never been and never will be.

  9. Regarding super-regulators, remember Baseline’s post on Greenspan?

    Well, here’s another choice quote from Paul Samuelson about our regulators…

    “And this brings us to Alan Greenspan, whom I’ve known for over 50 years and who I regarded as one of the best young business economists. Townsend-Greenspan was his company. But the trouble is that he had been an Ayn Rander. You can take the boy out of the cult but you can’t take the cult out of the boy. He actually had instruction, probably pinned on the wall: ‘Nothing from this office should go forth which discredits the capitalist system. Greed is good.’

    However, unlike someone like Milton, Greenspan was quite streetwise. But he was overconfident that he could handle anything that arose. I can remember when some of us — and I remember there were a lot of us in the late 90s — said you should do something about the stock bubble. And he kind of said, ‘look, reasonable men are putting their money into these things — who are we to second guess them?’ Well, reasonable men are not reasonable when you’re in the bubbles which have characterized capitalism since the beginning of time.

    But now Greenspan admits he was wrong.

    Because we had, instead of three standard deviations storm, a six standard deviation storm. Well, we did have something unprecedented. I think looking for scapegoats and blame can be left to the economic historian. But, at the bottom, with eight years of no regulation from the second Bush administration, from the day that the new SEC chairman — Harvey Pitt — said ‘I’m going to run a kinder and gentler SEC,’ every financial officer knew they weren’t going to be penalized.”

  10. There may have been a few (Jim Grant) who argued that low interest rates are not an unalloyed good thing, but they were few and far between. Remember when “Easy” Al Greenspan was practically (except amongst us smart people)worshipped as the “Maestro” (I can’t help but remember that Seinfeld episode)and was hailed as a member of the committee to save the world???
    hmmmmm….I wonder if he would have been very popular if he had set out to “pop” the obviously overvalued stock market. Wonder if he would have been reappointed?

  11. There will always be bubbles, in the sense that, in the universe of capital allocation, there will always be some segment that is less efficient.

    In other words, there will either be perfect equilibrium, or a bubble(s). So the idea that we can eliminate or prevent all bubbles is illusory.

    Given that, the question before us should be how to minimize bubbles, and how to isolate their impact.

    As always, I think we need to start with reducing leverage and complexity.

    Complexity feeds bubbles by obscuring their existence through a reduction in market information. Leverage is the mechanism by which they metastasize.

    Focussing on these two problems would be a good place to start.

  12. Thank you for finally explaining that so well. This is just one more reminder that the only real way to keep our economy strong is not by raising taxes, but by keeping taxes low, fair and simple. I’ve been looking for a way to take action and contact our legislators and sign petitions and found some good policy the U.S. Chamber of Commerce backs (here). I don’t have a lot of money or time, but I figure this will help other people do good.

  13. Janet Brown wrote, “This is just one more reminder that the only real way to keep our economy strong is not by raising taxes, but by keeping taxes low, fair and simple.”

    Huh? “Low, simple, and fair” are not consistent.

    The fairest tax is the tax on land value. It’s also very simple, and very difficult to evade. It’s also fair for the land tax rate to be set very high, because landowners as landowners don’t create any value at all.

  14. Paul wrote, “Except that construction cost in the Bush years rose even faster than housing prices, and in tight housing markets where there is economic growth and substantial housing demand, the replacement cost of housing has a huge impact on housing prices.”

    Nope. It wasn’t a housing bubble, but rather a land bubble. The fact that land is in fixed supply, and that land in “desirable” places is especially coveted, is why “housing” prices go up with income.

    Of course, stupid development restrictions (e.g. on density) make matters worse.

  15. I think that everyone should read Nick Rowe’s post:

    “What monetary policy cannot do, and so cannot be blamed for having done

    We have learned, after long and painful lessons, that there are some good things we wish that monetary policy could do that monetary policy in fact cannot do.

    But we don’t seem to have learned the corollary to that lesson: by exactly the same argument, there are also some bad things that monetary policy gets blamed for having done that monetary policy in fact cannot have done.

    I have stolen the title for this post from Milton Friedman. “What monetary policy cannot do” is a section heading from what is probably the single most influential paper on monetary policy in the last 50 years, “The role of monetary policy” (pdf). It is true that Mises and Hayek for example had previously made essentially the same point, but Friedman made it more clearly, and had a much greater influence on our way of thinking.”

    Here’s my point there:

    How would this work? Mortgage rates come down, say. Now, for some people, it will indeed be prudent and wise to buy a house when mortgage rates come down. However, it will not take long for this prudent investment to become dicey if home prices rise faster than other prices. Apparently, Glaeser says that Interest Rates can only account for at most 20% of the housing bubble. Even that seems high to me.

    So, at the beginning of a bubble, there will exist a certain amount of prudent and sensible investing. Can we really call that the cause of a bubble? It certainly comes first in time, and often leads to home prices going up. But I can’t, in good conscience, call this prudent behavior a cause of the bubble.

    I think that Angelo Mozilo, yes, that Angelo Mozilo, gave my view of the bubble when he testified before congress:

    Click to access 20080307121803.pdf

    “In June 2004, however, the Fed commenced what turned out to be 17 consecutive
    interest rate increases. The combination of increasing interest rates and higher
    home prices initially prompted a still higher spike in demand, as many borrowers
    rushed to buy homes for fear of getting priced out of the market.”

    There’s no way to make this prudent. In fact, it takes a cock and bull story to justify it. In my view, the story went like this:

    1. You cannot count on the govt for retirement.
    2. You cannot seem to save for retirement.
    3. You can buy rather than rent, and turn a cost into an investment.
    4. Housing prices are not coming down, so, if you don’t but now, then you never will.

    It’s a story of fear and panic, the fertile grounds where fraud and foolishness can plant themselves. Oddly, Mozilo gets closer to the truth than most economists.”

    The low interest rate argument doesn’t work. Neither will bursting bubbles by using the Fed’s short term interest rates. In fact, rates were rising during some of the years with the worst loans. Let me quote Burke:

    “History is a preceptor of prudence, not of principles.”

    I would also recommend this post:

    “New Evidence on the Foreclosure Crisis
    Zero money down, not subprime loans, led to the mortgage meltdown.

    You can still help the less fortunate, by providing a cash subsidy for housing. That’s a much cleaner solution than messing with down payment requirements.

    It is also true that zoning and regulations can cause housing prices to rise. However, that it entirely separate from the question of sensible lending practices.

  16. To use a football analogy, it sounds like Dudley is engaging in the old Monday Morning Quarterback ploy. It’s an easy call from this side, given some powers (a new play book), and a new team (the current adminstration). But, it seems that the other team’s defensive unit, so far, is up to the task (PACS and oligarchs). AND, I am not convinced that we will experience any boom involving a bubble for many years, except for the unpredictable nature of the outcome of the current crisis making everything completely problematic to predict.

    I think that we are on the cusp of a greater decline than last Fall’s, all things considered. The green shoots are now dead, so what’s the point in rhetoric which takes us nowhere in the current sense. Dudley is achieving didley by filling the air with the useless sounds of his flapping lips. We need some economic psychologist to step to the forefront and create a sane playing field. Right now, it’s so slanted that the players can’t stand up.

  17. “Is there also an effective bubble in US Treasuries…?”
    Does the Japanese Ministry for Treasury think so?
    This isn’t my area – does anyone here know for sure that the Chiasso incident can be dismissed as unimportant, even _if_ the Treasury bonds are forgeries?

  18. You Said:
    “Of course, if the Fed can’t get better at spotting bubbles, the implication is that no one can. Which means that “macroprudential regulator” is just a slogan – a nice piece of what Lenin liked to call ‘agitprop’.”

    Bubbles are book-keeping 101. A proper book-keeping defines asset value and assigns liability’s identity. In a bubble assets have been improperly defined. The imaginary $ assigned to liability has no meaningful calories. It is like eating junk food and expecting to be nourished. The “financial industry” as they like to call themselves shows very little sign of doing a proper book-keeping. Until rigorous double-entry book-keeping has a real asset for every liability on its books, you are going to have a bubble that in time will burst.
    Dan Palanza

  19. Hello…
    On the matter of whether or not financial bubbles are like tides, I take this to be something akin to Hobbes’ beast gone mutant (it has been a few centuries). Hobbes himself points out that ‘the reader needs to recall that the leviathan is not really natural but is a fabrication of man’… (sorry, I am at work and honestly can’t take the time to fish out that reference). To me the meaning therein is that science and theory have to evolve to understand the ‘beast’.

    Your blog from July 2nd offered up a link to an interesting article co-authored by Anil Kashyap. Wasn’t that paper at least aiming at macroprudential measures? – though as you point out (bang on I think), its major weakness is its disconnect with political economy. To me, this is exactly where theoretical evolution is needed. On the other hand, the idea that ‘if the fed can’t spot the financial bubbles (of nature) than no can’, reminds me that I better get back to my secretary job on the double.:) But then, (I love the internet) I read that the Vatican
    is doling out advice to economists leading our world economy – god knows where! Funny that Hobbes was trying to get away from divinely inspired leadership. Should we really place all our hope with the superstars at the Fed and just watch the tides?:)

    MC Morley

  20. It would be easy to deal with stock price bubbles OR housing price bubbles, and you wouldn’t have to get monetary policy involved. Just decrease the amount of leverage allowed in purchasing stocks or real estate.

    For stocks, that would be easy – increase the margin requirements. That would be a good idea anyway. Why anyone in the world is allowed to borrow money to buy stocks is more than I can understand.

    There are at least two ways to pop a housing bubble or a commercial real estate bubble that wouldn’t involve monetary policy – one increase the amount of down payment required, or, two, require banks to keep larger loan reserves for housing mortgages.

    All of these solutions could easily be implemented without any additional legislation. What we have here is a failure of will in the regulators.

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