Fault Lines: How Hidden Fractures Still Threaten the World Economy (21 page)

Instead, the Fed watched while stock prices continued rising in the dot-com boom, as companies without earnings or even revenues sold shares at astronomical prices based on the number of “eyeballs” they attracted to their websites. The Fed even cut rates following the Russian debt default in 1998 and the collapse of the hedge fund Long-Term Capital Management, and raised interest rates mildly starting only in 1999.

When the stock market eventually crashed in 2000, the dramatic initial response by the Fed ensured that the recession was mild even if job growth was tepid. In a 2002 speech at Jackson Hole, Alan Greenspan now argued that although the Federal Reserve could not recognize or prevent an asset-price boom, it could “mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”
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This speech seemed to be a post facto rationalization of why Greenspan had not acted more forcefully on his prescient 1996 intuition: he was now saying the Fed should not intervene when it thought asset prices were too high but that it could recognize a bust when it happened and would pick up the pieces.

The logic was not only strangely asymmetrical—why is the bottom easier to recognize than the top?—but also positively dangerous. It fueled the flames of asset-price inflation by telling Wall Street and banks across the country that the Fed would not raise interest rates to curb asset prices, and that if matters went terribly wrong, it would step in to prop prices up. The commitment to put a floor under asset prices was dubbed the “Greenspan put.” It told traders and bankers that if they gambled, the Fed would not limit their gains, but if their bets turned sour, the Fed would limit the consequences. All they had to ensure was that they bet on the same thing, for if they bet alone, they would not pose a systemic threat.

Equally important, the willingness to flood the market with liquidity in the event of a severe downturn sent a clear message to bankers: “Don’t bother storing cash or marketable assets for a rainy day; we will be there to help you.” Not only did the Fed reduce the profitability of taking precautions, but it implicitly encouraged bankers to borrow short-term while making long-term loans, confident the Fed would be there if funding dried up. Leverage built up throughout the system.

For a long time, central banks justified not focusing on asset prices by arguing that if Alan Greenspan had acted on his intuition in 1996, he would have snuffed out a boom that, despite the slump in 2000, took the stock market and U.S. household wealth to unprecedented heights. On March 2, 2009, though, the S&P 500 closed at 700, below its level of 744.38 on the day in 1996 when Alan Greenspan made his fateful speech. Of course, to date it has regained substantial ground, but perhaps Greenspan could have averted thirteen years of lost returns if indeed he had backed his words with action on interest rates. Whether the political system would have allowed him to do so is, of course, another matter.

The recent recession has started some rethinking on the objectives of monetary policy, though even as I write, the Fed is keeping interest rates at rock-bottom levels because unemployment is high, even while all manner of asset prices are rising. The saving grace today is that credit growth is still tepid, and it is unlikely that we will have another housing boom while memories of the last one are still fresh. But the financial sector is, if anything, innovative, even in the ways it gets into trouble!

I said earlier that academics and central bankers had converged on the view that there is no incompatibility between the objectives of seeking maximum growth and keeping inflation low in the long run. But there does seem to be some incompatibility between the monetary policies that encourage real investment and growth—maintaining predictably low interest rates over a sustained period and expressing a willingness to flood the market with liquidity when it is tight—and the monetary policies that discourage the coordinated one-way bets by financial market participants that have proved so damaging—pursuing unpredictable policies with no assurance of liquidity support.

The argument that monetary policy has no role in leaning against asset-price bubbles is both timid and self-serving, and it takes the Fed out of a key role it can play in assuring financial stability. Of course the Fed should proceed cautiously and lean against an incipient bubble only when there is substantial evidence that it exists, tempered by the knowledge the fears of a bubble could be baseless. To resign the role of party pooper, however, is to buy political acceptability at great risk to the economy.

More controversial is whether the Fed should cut policy interest rates to rock bottom in order to revive the economy. Although such an action seems costless, it imposes an enormous cost on savers and offers an enormous windfall to debtors, especially banks. Because it is a relatively hidden transfer, it elicits little comment or protest, especially as well-off savers tend to keep their heads down at times of crisis. But it is a transfer nevertheless, amounting to hundreds of billions of dollars a year. Moreover, it offers a one-way bet to bankers: plunge the system into trouble, and they will get a great deal on interest rates. Finally, it is not clear that ultralow nominal interest rates (around 0 percent) offer a significantly greater incentive for firms to invest than merely low interest rates (2 to 3 percent), but the difference in risk taking between ultralow and low interest rates could be enormous.

More damaging still is the Fed’s ongoing attempt to prop up housing prices, both indirectly through low interest rates and directly by lending into the housing market. Although such support is justified as a way to allow the bubble to deflate slowly, it contributes to prolonged delays in adjustment in the housing market. Instead of homeowners and lenders biting the bullet on losses and moving on, they have the incentive to wait and see. But so long as there is a prospect for further adjustment, buyers, too, stay out of the market. And unless the oversupply in the housing market is cleared out, builders have little incentive to resume construction. The Fed could be not only delaying the recovery of the housing market but also reinforcing the sense that it will not get in the way of price increases but will prevent price falls. The Greenspan put is quickly becoming the Bernanke put.

In sum, the Fed’s conduct of monetary policy between 2002 and 2005, while roundly criticized by all but central bankers and monetary economists (with notable exceptions), had two important limitations. First, it was fixated on the high and persistent unemployment rate and did its best to bring it down by trying to encourage investment. It signaled that it would keep rates low for a sustained period and offered the Greenspan put if firms were still not convinced. Critics should recognize that this fixation was in full accord with its mandate and, more important, that there would have been political hell to pay if it had raised interest rates much earlier than it did. This policy, however, may have had a greater effect on credit growth and asset prices than on job creation outside the real estate industry: corporations were still working away the excesses of the dot-com boom.

Second, the dominant academic orthodoxy indicated that so long as inflation was quiescent, central bankers had nothing to worry about. Indeed, to worry was to destroy the purity of the theoretical system that had been built, for that would admit of multiple objectives and lead to market confusion. Instead, central bankers should keep their eyes fixed on inflation (or the lack thereof) and let bank supervisors worry about risk taking. Unfortunately, the supervisors had been muzzled, this time on the ideological grounds that they would do more harm than good by restraining the private sector.

The bottom line is that the debate over monetary policy, which was once thought settled, will have to be reopened again. Among the most pressing issues are the trade-offs between policies intended to generate investment and employment and policies intended to ensure financial stability. Asset-price inflation will have to enter the policy debate. Moreover, the Fed will have to consider whether it is setting policy only for the United States, or, in reality, for a much larger global economy. Much needs to be done.

This is as good a point as any to try to understand the failings of academic economists in the macroeconomic sphere. Many commentators have gone overboard in poking fun at economists’ models, deriding them as oversimplified. Others wonder about the excessive mathematical complexity of some modeling, and yet others combine the criticisms by arguing that human behavior is too complex to be captured by mathematical models.

The most realistic model would be one that details all individuals and their whimsical behavior, and all institutions, but it would be hopelessly complex and of little value in analysis. The whole point of economic modeling is to create useful simplifications of the economy that allow us to analyze what might happen under varying policies and conditions. The test then is whether the model is a useful simplification or an oversimplification.

Many past macroeconomic models had a single representative agent making all decisions. The representative-agent models were easy to work with and did offer useful predictions about policy, but they took for granted the plumbing underlying the industrial economy—the financial claims, the transactions, the incentive structures, the firms, the banks, the markets, the regulations, and so on. So long as these mechanisms worked well, the models were a useful simplification. And during much of the “Great Moderation” that Bernanke referred to, the plumbing worked well and served as a good basis for abstract reasoning.

But as soon as the plumbing broke down, the models were an oversimplification. Indeed, the models themselves may have hastened the plumbing’s breakdown: with the Fed focused on what interest rates would do to output rather than to financial risk taking (few models had a financial sector embedded in them, let alone banks), financial risk taking went unchecked.

In a haunting parallel to Robert Lucas’s famous critique of Keynesian models, in which he argued that those models would break down because modelers did not account for how the economy would react to policies that attempted to exploit past correlations in the data, modeling that took the plumbing for granted ensured the breakdown of the plumbing. In coming years, macroeconomic modeling must incorporate more of the plumbing, which has been studied elsewhere in economics.

The danger is that monetary economists will try to wish away the links between monetary policy, risk taking, and asset-price bubbles. Bernanke came close to doing so in his 2010 speech to the American Economic Association, where he argued that it was not the Fed’s defective monetary policy—which he considered entirely appropriate, given the Fed’s views on inflation—but its inadequate supervision that helped trigger the crisis. He concluded: “Although the most rapid price increases occurred when short-term interest rates were at their lowest levels, the magnitude of house price gains seems too large to be readily explained by the stance of monetary policy alone. Moreover, cross-country evidence shows no significant relationship between monetary policy and the pace of house price increases.”
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Of course, no one claims that the Fed alone was responsible for the housing debacle. Government policies favoring low-income housing, as well as private-sector mistakes, contributed significantly. But to suggest that it had no role is disingenuous. Indeed, a detailed study published in the
Federal Reserve Bank of St. Louis Review
in 2008 presents evidence that “monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off the perceived risks of deflation in 2002–2004 has contributed to a boom in the housing market in 2004 and 2005.”
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Moreover, there is no reason why there should be a strict relationship across countries between monetary policy and the rate of house-price growth over any common period of time: the rate of price growth might depend on a variety of factors that are specific to each country, including how high house prices already are.
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The broader point is that monetary economists need to take note (as they are now doing) of the other channels through which monetary policy might have effects.

As developing countries cut back on demand following their crises in the 1990s, and as industrial-country corporations worked off their excess investment following the dot-com bust, the world’s exporters searched once again for countries that would reliably spend more than they produced. The United States, which was already pushing to encourage household consumption to appease those left behind by growth, had added reasons to infuse substantial fiscal and monetary stimulus in response to the downturn: the jobless nature of the recovery and the weak U.S. safety net. In addition to a substantial fiscal stimulus that pushed a government budget that was temporarily in surplus into large fiscal deficits, the Fed kept its foot pressed on the monetary accelerator, even while giving all sorts of assurances to the markets on its willingness to maintain easy monetary conditions and to step in to provide liquidity in case the financial markets had problems. These assurances had the desired effect of leading to an explosion of lending, which unfortunately continued expanding and deteriorating in quality even after the Fed started tightening. For an unsustainable while, though, the United States provided the demand the rest of the world needed.

The U.S. political system is acutely sensitive to job growth because of the economy’s weak safety nets. The short duration of unemployment benefits in the United States, as well as the substantially higher costs of health care for those who do not have jobs, were not excessively painful when recessions were short: they gave laid-off workers strong incentives to find new jobs even while U.S. businesses created them. But if recessions are likely to be more prolonged than in the past, the system has to change, if only because the old social contract—short-duration benefits in return for short recessions—is breaking down.