Unfettered Liquidity Sustains a Bubble

Two articles from this week's The Economist magazine shed more light on the different approaches to monetary policy around the world. One thing that is always odd about reading this magazine is, since there are no bylines, you never know who wrote the article you are reading, so you never get conditioned to expect a particular point of view.

From the writer's perspective, not having their name attached to a story probably allows a bit more freedom to say what's really on their mind given that only their co-workers likely know which writer penned a particular story.

Whoever's doing the writing, the first story is about this week's monetary policy meeting and the issues facing Ben Bernanke as he settles into the big chair at the head of the table in the Federal Reserve Board conference room.

Among the myriad questions facing the most powerful central banker in the world, the one that has gotten the least attention in newspapers lately is the Fed Chairman's crisis management skills, now that The Maestro has left the orchestra pit with members of the brass section in tow.

What may be missing, now that Messrs Greenspan and Ferguson have gone, is experience of managing crises. Mr Ferguson was the man in charge on September 11th, 2001. Now Mr Kohn and Tim Geithner, president of the Federal Reserve Bank of New York and a Treasury official in the Clinton administration, are the only veterans of turbulent times. But maybe not too much should be made even of this. Mr Greenspan, after all, made his name as a steady man in a crisis for his handling of the 1987 stockmarket crash, shortly after he took the chair. If push comes to shove, Mr Bernanke could win a similar reputation.

It will be fascinating to watch the crisis management team swing into action, should their services be required. It's hard to imagine that Treasury Secretary Snow would be of much help in such an instance - his capacity for instilling confidence in markets has surely been diminished after years as the pitchman for White House economic policies.

The low-profile head of the Bank of New York, Tim Geithner, would probably be the go-to guy in the event of a crisis, which is bound to happen someday. Although, as the weeks and months go by it seems that the possibility of a crisis becomes more and more remote. Looked at another way, as Alan Greenspan once mused, it is possible that stability is breeding instability.

On interest rates and the economy, mixed signals abound.

The trouble is that America's economy is sending conflicting signals. Some numbers, such as the low saving rate and the colossal current-account deficit, suggest that the economy's course is unsustainable.

Despite the Fed's rate rises, overall financial conditions have remained loose: bond yields, in particular, have stayed unusually low, though they have picked up lately (see chart). The latest statistics say that while the economy is, if anything, proving stronger than expected, inflation remains surprisingly tame.
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Although Mr Bernanke admits that the housing market is a risk, he seems less concerned about the effect of lower house prices than his predecessor was. Last year Mr Greenspan gave several warnings that a slowdown in the housing market could hurt consumption. Mr Bernanke appears to think mortgage-equity withdrawal less important in boosting spending than Mr Greenspan did, and to believe that solid wage and job growth are now supporting consumption. He seems confident that even if interest rates continue to rise, the effect on households' mortgage costs will be gradual.

Someday, all of Alan Greenspan's warnings from 2005 will have to be gathered and presented in a single story. Collectively, they paint a picture of uncertainty, caution, and perhaps danger, but when considered individually, they really didn't seem too much of an impact at all.

What was the motivation? The ability to speak more freely with one foot out the door? An awakening of sorts regarding what he was leaving behind? Maybe his 2007 book will answer some of these questions.

In summary, the task ahead for Ben Bernanke is not a simple one.

What all this means for short-term interest rates is unclear. The markets expect that rates will rise once more after next week and then stay at 5% for a while. But if the economy is as resilient to weaker house prices as Mr Bernanke seems to believe, rates might have to go up again. If spending is dragged lower, rates might be too. Whichever happens, Mr Bernanke must pick his course with care.

Yes, pick your course with care, and don't let this image linger in your consciousness.

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The second story, is much more interesting than the first, and in case you've been wondering about the title of this post, the wait is almost over. As it is a subscribers-only article, it has been dutifully copied in its entirety and now appears as the previous post here. The story deals with the question of monetary policy and the importance of the money supply, a topic that was covered briefly here and here last week.

Two events in the past week highlight the huge divide in monetary policy thinking between Europe and America. On March 16th and 17th, a conference was held in Frankfurt to honour Otmar Issing, chief economist of the European Central Bank (ECB), who retires in May. Most participants agreed that central banks still need to watch the growth of the money supply. A week later, America's Federal Reserve stopped publishing M3, its broadest measure of money, claiming that it provided no useful information. Who is right?

Mr Issing was the architect of the ECB's monetary-policy strategy. He built it using a design taken from Germany's Bundesbank, where he was previously the chief economist. He holds two controversial beliefs that challenge prevailing monetary orthodoxy. First, he thinks that central banks must always keep a close eye on money-supply growth. Second, central banks sometimes need to lean against asset-price bubbles.

Money supply growth and asset bubbles - two things that central bankers should watch closely. Not coincidentally, Germany is one of the western economies that has not been swept up in the housing mania that has infected much of the western world.

Germany also has a trade surplus - there must be a connection there somewhere.

But it would be foolish to conclude that money does not matter. Throughout history, rapid money growth has almost always been followed by rising inflation or asset-price bubbles. This is why Mr Issing, virtually alone among central bankers, has continued to fly the monetarist flag.

The ECB's monetary-policy strategy has two pillars: an economic pillar, which uses a wide range of indicators to gauge short-term inflation risks, and a monetary pillar as a check on medium- to long-run risks. The monetary pillar has attracted much criticism from outside the ECB; it is often dismissed as redundant, if not confusing. It was originally intended to guard against medium-term inflation risks. More recently, Mr Issing has justified the pillar as a defence against asset bubbles, which are always accompanied by monetary excess.

Redundant and confusing, yes, but worst of all, an undue influence of money supply growth on formulating monetary policy is no fun. This restricts the rise in asset prices. When asset prices rise, everyone gets rich, and since asset prices are not included in inflation statistics, economists can say that inflation is low - that they are doing their job. Simple. Prosperity for all.

Unlike some central bankers, Mr Issing loves to be challenged, so he invited Don Kohn, a governor of the Fed, to tackle the ECB view that a central bank should sometimes “lean against the wind” to prevent an asset bubble inflating, by tightening policy by more than inflation alone would require. Mr Kohn argued the usual Fed line: because of huge uncertainties, it is too risky to respond to bubbles and therefore it is safer to “mop up” by easing policy after a bubble bursts. He tried to present the Fed's approach to asset prices as the neutral one, ie, less activist than the ECB's. But that is misleading. There is no such thing as “doing nothing”. Under the Fed's approach, unfettered liquidity sustains a bubble.

And there it is - unfettered liquidity sustains a bubble.

Money supply growth that is two or three times the reported inflation rate, when combined with creative mortgage finance products originating on Wall Street and consumed by wary Asians and pension fund managers - that's what makes a bubble economy keep ticking.