With respect to our current economic woes, we have long passed the point of no return. The sad part of it is not the loss wealth, which could be recuperated, but the loss of intellectual rigor and economic wisdom. This is quite evident in a recent Op-Ed (“Not all bubbles present a risk to the economy”…FT, 11/9/2009) by Frederic Mishkin, former FED governor and current Professor of finance & economics at Columbia University. Some of the stuff he writes is absolute silliness, which only a bureaucrat, politician, and most professional economists would believe.
Let’s digest a little bit of what he says. My comments are in bold
There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no.
The introduction is just setting the stage of his argument: happy days do not have to end.
Are potential asset-price bubbles always dangerous? Asset-price bubbles can be separated into two categories. The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.
Prof. Mishkin omits important variables necessary to answer the following questions: who creates money? How is money created? The omitted variables are Federal Open Market Committee and fractional reserve banking. Leverage, without concomitant increase in the supply of money, cannot by itself cause the effects Prof. Mishkin outlines.
Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.
This is malinvestment repriced to reflect the true (subjective and imputed) value by the market. In this environment, prices decline.
The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.
Mr. Mishkin is a trademark politician. Notice the terms he throws out there: “does much less damage” or “not accompanied by a marked deterioration in bank balance sheet.” He fails to mention his standard of comparison. But, why would he? Doing so might expose his dillusion.
The reason prior bubbles did not have the level of impact as the current one has to do where the printed money by the FED made its way through the economy. Money enters through the financial system. Financial firms dealt with each other in the form of opaque instruments, which had little genuine economic value. When the implosion occurred, there was a high level of expected risk that financial firms would go belly-up. As a result, credit in essence stopped flowing. Since other non-financial (as well as financial) companies rely on a smooth flow of credit to finance their day-to-day operations, the result was catastrophic. Prior bubbles did not have this dimension magnified to the extent we recently experienced.
Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.
Mr. Mishkin states that if policymakers were clairvoyant and “smart, why aren’t they rich?” In fact, they are rich in comparison to median household income. More egregious is the fact that monetary policymakers are the culprits of the economic crisis we are enduring presently. Summers, Geithner, Bernanke, et. al. are jus a few names who were around in policymaking circles while the current bubble was being inflated. Of course, let us not omit Mr. Mishkin. They never saw it coming. But, somehow today we are led to believe that they see “green shoots” and that everything is and will be just fine. If this is not a contradiction, then I don’t know what is.
Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.
Here is one that is almost never considered, let alone even think: abolish the Federal Reserve.
But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.
Mr. Mishkin, who is providing credit right now? The Federal Reserve System. Simply look at the size of its balance sheet. Yes, I know, it is technically part of the money supply in the form of the monetary base. But the effects are the same as credit. The bubble that is being inflated is in Treasury debt.
Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture. The Fed decision to retain the language that the funds rate will be kept “exceptionally low” for an “extended period” makes sense given the tentativeness of the recovery, the enormous slack in the economy, current low inflation rates and stable inflation expectations. At this critical juncture, the Fed must not take its eye off the ball by focusing on possible asset-price bubbles that are not of the dangerous, credit boom variety.
La! La! La! I am selling the George Washington Bridge…any takers? Mr. Mishkin?