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Three Sins, One Gift - Sin #1

Wednesday, January 28, 2009

Leading into Saturday's three-year anniversary of the retirement of former Fed Chairman Alan Greenspan, the January 2006 series "Three Sins, One Gift" is being repeated this week. Note the bonus "Greenspan mess" sighting at the end - as always, The Economist was very early on this one (but not quite as early as this blog).

Original publication date: January 13th, 2006

A story in The Economist this week has prompted an early kick-off to a series of posts at this blog - a series that had already been planned for later this month, but which begins today instead. The series is intended to shine light on three sins committed by departing Federal Reserve Chairman Alan Greenspan, who is set to step down on January 31st.

On that day, the final installment will detail the gift he has bestowed.

As anonymous economists at The Economist have already done most of the heavy lifting required to make the case for sin number one, Ignoring Asset Prices, attempting to recreate those arguments here seemed an unproductive use of time.

Their well-reasoned points have been liberally excerpted below, however readers are encouraged to enjoy the original accounts in their entirety - Monetary Myopia , and the cover story, Danger Time in America.

They are masterfully written and available at no cost.

Sin #1 - Ignoring Asset Prices

The legacy of Alan Greenspan is now inextricably intertwined with, and will likely suffer the same fate as, the over-inflated American real estate market.

If housing cools painlessly over the next few years reverting to more normal levels of growth that are sustainable into the next decade, and if over-extended homeowners successfully adjust to a changing world of reduced expectations, then, and only then, will current criticism of the outgoing Fed Chair have been proved both premature and ill-advised.

If, over time, the citizenry maintain much of their currently elevated standard of living, as they have been led to believe is nearly an inalienable right, then the departing chairman will have demonstrated that his detractors were wrong, and will have rightfully earned the praise that accompanies being universally regarded as the greatest central banker in history.

Many believe these rosy scenarios are unlikely and that ignoring asset prices has been sinful.

Today, on the surface, the American economy is the model for the rest of the western world - robust GDP growth, low unemployment, and low inflation.

By most statistical measures emanating from Washington, we are living in a "goldilocks" economy - a sort of dream world where no shocks to the system can derail growth or prosperity - wars, hurricanes, deficits, political intrigue - none of it matters.

But where would we be without rising home prices?

Rising home prices, following historically low interest rates held far too low for over two years, have enabled home equity withdrawal at unheard of rates. This has supported personal consumption which now contributes to GDP growth as never before in history, and has resulted in the creation of millions of housing related jobs.

This has seemingly worked wonders in response to the bursting of the stock market bubble at the turn of the century, but with housing now beginning to cool, the natural question to ask is, "Where do we go from here?"

Like stocks in the late 1990s, why were home prices allowed to rise at many times the rate of inflation, leading all to believe that prosperity would be eternal?

The Economist asks the same questions.

The Economist's long-running quarrel with Mr Greenspan is that he chose not to restrain the stockmarket bubble in the late 1990s or to curb today's housing bubble. He has declared himself vindicated in not pricking the equity bubble with higher interest rates, but instead to let it burst and then cut rates sharply to “mop up” the damage. The economy has fared better than we expected since share prices slumped, with only a mild recession in 2001. But a better test of Mr Greenspan's policies is not whether America escaped a deep recession, but whether the economy would today be on firmer foundations if the Fed had acted against that bubble.

How monetary policy should respond to increases in the prices of assets such as houses or shares is the biggest dilemma facing central banks everywhere. The Fed takes account of rising asset prices to the extent that they boost spending and hence future inflation. But the burning question is: should it respond to asset prices even if inflation seems under control? Three main arguments are given by Mr Greenspan and his colleagues for why central banks should ignore asset prices other than their impact on inflation. First, that monetary policy focused on inflation and growth is the best way to achieve economic stability. Second, that one can never be sure that what looks like a bubble really is a bubble. And third, that interest rates affect the economy more like a sledgehammer than a scalpel. A modest rise in rates is unlikely to halt rising share prices, but an increase sufficient to pop the bubble would slow the whole economy and could even cause a recession. Mr Greenspan thus concludes that it is safer to wait for a bubble to burst by itself and then to ease monetary policy to soften a downturn.

Consider each of these arguments in turn. First, the job of a central bank is not just to prevent inflation, but also to ensure financial stability. Yet the three biggest stockmarket bubbles in the past century—America's in the 1920s and 1990s and Japan's in the 1980s—all developed when inflation was low. Arguably, Mr Greenspan has defined the role of monetary policy too narrowly. Inflation is often described as too much money chasing too few goods. But in a world awash with cheap money and with potent new sources of supply, such as China, to hold prices down, inflation will remain low and so fail to signal if an economy is overheating. Increased central-bank credibility also helps to anchor inflation. If central banks hold interest rates low, this will encourage risk-taking in financial markets and excess liquidity will spill over into asset prices rather than traditional inflation.

Asset-price inflation can be as harmful as conventional inflation. A sudden collapse in share or house prices can trigger a deep downturn. And surging asset prices also distort price signals and cause a misallocation of resources—by encouraging too little saving, or too much investment in housing, so reducing future growth. This is why central banks need to pay closer attention to asset prices.

Second, it is not, as Mr Greenspan argues, impossible to identify bubbles. When prices have lost touch with fundamentals and there are other signs of excess, such as rapid credit growth, alarm bells should ring. Mr Greenspan's “irrational exuberance” speech in December 1996 shows he was concerned about a bubble inflating long before the bubble reached its full extent. And transcripts of meetings of the Federal Open Market Committee (FOMC, which meets to set interest rates) now make clear that several Fed officials were fretting about the bubble in 1998 and 1999. At the December 1999 meeting, when discussing the stockmarket, Mr Greenspan said: “It is only a question of how much of a bubble there is.”

Moreover, central banks do not have to be certain they have identified a bubble before they act. Monetary policy has constantly to deal with uncertainty—such as the size of the output gap. Uncertainty is a reason for responding cautiously, but not for doing nothing.

What of Mr Greenspan's third claim that, even if a central banker is pretty sure there is a bubble, there is little he can do about it because interest rates are a blunt tool? In August 2005 Mr Greenspan said: “Given our current state of knowledge, I find it difficult to envision central banks successfully targeting asset prices any time soon.” But he was setting up a straw man. Nobody is seriously arguing that central banks should “target” a particular level of asset prices. Most economists accept that aggressive action to “prick” bubbles could also be risky. Instead, the debate today is whether central banks should “lean against the wind” when asset prices appear dangerously out of line with fundamentals, raising interest rates by a bit more than inflation alone would call for.
While quarreling with the use of the word "inflation" to casually exclude the cost of housing, there is little else to object to here. These are the same points made on a number of occasions in these pages.
  1. Asset prices affect long-term stability
  2. The formation of asset bubbles can be detected
  3. Monetary policy can be used to combat rising asset prices
Regarding the last point, it seems reasonable that regulation of mortgage lending should work alongside monetary policy to do what is in the best long-term interests of an economy, impinging as little as possible on the operation of free markets.

The role of the Federal Reserve and other government agencies in this area has been much too little and far too late to have any meaningful effect on the consequences that are likely to arise as a result of credit that has already been extended.

The horse has long since left the barn, as they say.

Fittingly, Monetary Myopia concludes with a drinking analogy that refers to today's economy as a "mess". We are humbled and gratified that The Economist shares our view, and find it impossible to resist closing with these words as well.
In December Mr Greenspan was made a Freeman of the City of London. One of the traditional perks of this honour is that he can be drunk and disorderly without fear of arrest. The snag is that his policies have also encouraged drunk and disorderly asset markets and intoxicated consumers. When the party ends, Mr Greenspan will not be there to clean up the mess. But end it surely will.


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