John Taylor thinks that the Federal Reserve is to blame for the crisis because of the low interest rates

TO BE NOTED: Antonio Fatas and Ilian Mihov on the Global Economy:


"Three different views on the role of monetary policy leading to the current crisis

John Taylor thinks that the Federal Reserve is to blame for the crisis because of the low interest rates in the year 2003-2005 period.

"Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust."

You can see the full article at the Wall Street Journal (Feb 9, 2009).

Alan Greenspan, as you would expect, disagrees with John Taylor and claims that the central bank was doing the right thing but the problem was the disconnect between short-term interest rates and mortgage rates (which were being kept too low partly because of the increase in saving rates coming from Asia).

"Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.""

You can see the full article at the Wall Street Journal (March 11, 2009).

Lucas Papademus, Vice President of the ECB looks forward in a recent speech (May 15, 2009) and asks what monetary policy should do in a similar future situation. He advocates for a symmetric reaction of monetary policy: not only it makes sense to lower rates when the crisis starts but central banks should also act when financial imbalances are accumulating.

"In order to reduce such potentially dangerous side-effects of non-standard measures of liquidity provision and of the very low policy rates during a crisis, monetary policy would have to be sufficiently tightened during the financial boom phase. Such a policy would dampen financial market excesses through two channels. It would tend to reduce asset prices by increasing the rate at which an asset’s future income stream is discounted. Most importantly, the anticipation of such a policy response would reduce the likelihood of a speculative bubble emerging in the first place, by affecting investment behaviour and reducing the level of risk incurred by financial intermediaries in their lending."

Papademus falls short of making a statement on whether interest rates were too low during the years that preceded the crisis (as Taylor argues). But his argument supports the view that standard monetary policy (i.e. via interest rates) also has a role to play in dealing with speculative bubbles in financial markets, it is not just a matter of proper regulation and supervision.

Antonio Fatás"

"who has admitted that interest rates are only a "blunt instrument" with which to control the economy."

A banker speaks. From the Guardian:

• Julia Kollewe
• guardian.co.uk, Monday 22 December 2008 11.29 GMT
• Article history

The Bank of England underestimated the severity of the current financial crisis, according to its deputy governor, who has admitted that interest rates are only a "blunt instrument" with which to control the economy( I AGREE WITH THIS, WHICH IS WHY OPPOSE ITS USE TO STOP BUBBLES ).

Sir John Gieve told the BBC's Panorama programme, to be screened tonight, that new tools were needed to complement interest rates. He also admitted that the Bank knew "crazy borrowing" was taking place and the price of houses and other assets was rising unsustainably, but did not fully understand the problem( IT SOUNDS LIKE THEY DID. WHAT WAS UNDERESTIMATED WAS THE SEVERITY OF THE CRISIS AND INEFFECTIVENESS OF GOVERNMENT INTERVENTION. I BELIEVE THAT HIS STATEMENT LENDS CREDENCE TO MY THESIS ).

"We didn't think it was going to be anything like as severe as it's turned out to be( BINGO! )," said Gieve, who is in charge of financial stability at the Bank. "Why didn't we see that it was so serious? I think that's because we, perhaps, we hadn't kept pace with the extent of globalisation. So the upswing here didn't involve the big increases in earnings and consumption and activity which we saw in previous booms. We saw the credit, we saw the house prices, but we did see a fairly stable pattern of earnings, prices and output."

Tim Besley, another member of the Bank's monetary policy committee, was quoted in the Daily Mail as saying there was "no quick or easy fix" to deal with the fall-out from the credit crunch and that measures other than monetary policy were needed( VERY TRUE ).

Sterling fell to a fresh record low against a trade-weighted basket of major currencies after the comments, hit by worries that British interest rates need to come down much further as recession bites( THEY WILL ). The euro climbed 1.5% to 94.72p, taking it close to its recent record high of 95.56p, which has led to the expectation that the two currencies will soon reach parity.

More powers needed

Explaining why the Bank did not raise interest rates to curb the lending and house price boom, Gieve said: "If we'd used interest rates to try and address this asset-price credit growth, we would have been holding down the level of activity elsewhere in the economy, in manufacturing, in other services, holding down the level of employment at a time when consumer price inflation and earnings were stable and reasonably low. And people would have said, you know, 'this is a wilful reduction in the prosperity of the country'."( WHAT HE JUST SAID IS WHAT I'VE BEEN SAYING )

The Bank could not rely only on interest rates to control the economy, Gieve argued. "One of the main lessons from this is that we need to develop some new instruments which sit somewhere between interest rates, which affect the whole economy and activity, and individual supervision and regulation of individual banks," he said. ( I AGREE )

"Maybe we need to develop something which bridges that gap and directly addresses the financial cycle and prevents the financial cycle and the credit cycle getting out of hand... I think we need to complement interest rates, which are a blunt instrument – you set one interest rate for the whole economy – with something which is more financial-sector specific."( I PREFER SUPERVISION OF THE INVESTMENT INSTRUMENTS, AND A STRICT FOLLOWING OF BAGEHOT'S PRINCIPLES )

Philip Shaw, chief economist at Investec, said the comments suggested that the "authorities recognise that more needs to be done to restrain borrowing booms because they are potentially destabilising." He noted that there had been numerous comments by Bank officials previously stating that interest rates could not be used to rein in borrowing because they were mainly designed to keep inflation on target.

Among the measures being considered by the government – to be adopted once the economy recovers – is a requirement for banks to hold more capital during good times( THIS MAKERS SENSE IF GOVERNMENT GUARANTEED ). Other measures could include legislation or guidelines on lending to households, Shaw said.( NO SPECIFICITY )

Gieve defended the Bank's performance in the crisis, which he called "a major storm we haven't seen the like of for 100 years". ( WE COULDN'T HAVE BEEN EXPECTED TO SEE IT COMING OR BEEN PREPARED TO DEAL WITH IT )

"It would be very surprising( SURPRISE ME ) if we weren't learning lessons from it and we are," he added.

Gieve also cast doubt( WAS REALISTIC ) on whether the Treasury would get all of the money back that it had poured into the banking sector, pointing to a "level of defaults" in the books of nationalised lenders Northern Rock and Bradford & Bingley, which were now held by the taxpayer.

Speaking on the same programme, John Varley, the chief executive of Barclays, predicted that consumers and businesses would struggle to get access to credit for the next one to two years."

There are some good points made here.

“We are in the midst of very difficult times for world financial markets and economies,” Kohn said.

Wise words from the Fed's Kohn. Just not in this WSJ post:

"Kohn did say that certain Fed programs including currency swap arrangements with other central banks as well as credit auction facilities “might be part of our permanent toolkit.”

Much of Kohn’s remarks dealt with past innovations in the financial sector and their effect on productivity and macroeconomic stability.

“Certainly, as financial innovations accelerated, we had solid reasons to believe that those advances were contributing to the pickup in overall productivity and, possibly, to the moderation in fluctuations of economic activity,” Kohn said.

While those innovations “did produce lasting gains,” Kohn noted that “these gains were clearly accompanied by increasing vulnerabilities,” especially in the housing market and the mispricing of risk.

“Ironically, an important contributor to these misalignments in spending and lending was the long period of economic expansion and low inflation over the past 25 years, interrupted only a few times by mild recession,” Kohn said.

“This good economic performance provided skewed data and bred complacency,” Kohn said.

Meanwhile, economic models used by central banks “are clearly inadequate” when it comes to the economic effect of the expansion and contraction of credit, Kohn said.

He also said it is unclear whether higher official interest rates a few years ago would have done anything to prevent the speculative bubble in housing or the erosion of lending standards. –Brian Blackstone

Here's my comment:

“This good economic performance provided skewed data and bred complacency,” Kohn said.”

For all I know this is true, but it sounds to me like saying we drove for miles and miles and miles and then we hit a wall. The skewed data bred complacency and so we stopped looking out the windshield.

Most of the proposed solutions like higher capital standards, etc., are very basic. I just don’t buy this line of explanation.

Comment by Don the libertarian Democrat - November 12, 2008 at 11:41 am

The Fed And Bubbles

Justin Lahart with an excellent post on the WSJ about the Fed trying to avoid bubbles in the future:

"Once authorities identify a bubble, the next step is figuring out how to deal with it. Fed officials appear uncomfortable with the idea of raising interest rates to prick a bubble, because rates affect a wide swath of economic activity, and a bubble may be confined to just one area.

"Monetary policy, for which we in the Federal Reserve are responsible, is a blunt instrument with economy-wide effects," said Federal Reserve Bank of Minneapolis President Gary Stern. "We should not pretend that actions taken to rein in those asset-price increases, which seemingly outstrip economic fundamentals, won't in the short run curtail to some extent economic growth and employment."

Fed officials are leaning toward regulating financial firms with more of a focus on how they are contributing to risk throughout the financial system. This approach could also have drawbacks, said Princeton economist Hyun Song Shin.

"These Wall Street people are very intelligent, and their incentives are so vast that they're going to find a way to go around the rules you set down," he said. "Leaning against the wind by raising interest rates in the face of what seems like a credit boom is one way of at least damping down on potential excesses."

This is the issue. If the Fed causes a slowdown in the economy in order to avoid a bubble, will that be accepted, or will people decry their action as limiting growth without enough cause. On the other hand, through lobbying and other means, they might not be able to deal with the problem companies effectively.