Opinion & Commentary
Bubble, toil and trouble
In December 1996, then US Federal Reserve Chairman Alan Greenspan famously mused ‘how do we know when irrational exuberance has unduly escalated asset values?’
Greenspan suggested the following answer to his own question: ‘We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in asset prices must be an integral part of the development of monetary policy.’
Greenspan’s view was that monetary policy should take account of the implications of asset prices for the real economy and consumer price inflation, but that asset prices per se should not be a target for policymakers.
In the context of the current global financial crisis, this orthodoxy is being questioned, not least by central bankers. Current Fed Chairman Ben Bernanke said in October that ‘the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy and there is no doubt that as we emerge from the financial crisis, we will all be looking at that issue and what can be done about it.’
In Australia, Reserve Bank Governor Glenn Stevens recently asked ‘whether something can and should be done to dampen the profound cycles in financial behaviour, with associated swings in asset prices and credit, given the damage they can potentially do to an economy.’ Stevens noted the view that ‘an effective response against the financial cycles almost certainly involves monetary policy’ and that ‘I sense now… that among many thoughtful people this question is once again up for discussion.’
Both Bernanke and Stevens stopped short of arguing that monetary policy should explicitly target asset prices, but the fact that the question is even being broached is potentially a seismic shift for modern central banking.
There are two great ironies underpinning this apparent shift in sentiment in response to the worst financial crisis since the Great Depression of the 1930s. First, an attempt by the Fed to manage stock prices was in fact the cause of the Great Depression. Second, Bernanke, more than any other contemporary scholar, has highlighted the dangers of using monetary policy to manage asset prices.
In 2002, prior to becoming Fed Chairman, Bernanke gave a speech titled ‘Asset “Bubbles” and Monetary Policy.’ Bernanke noted that ‘the correct interpretation of the 1920s is not the popular one – that the stock market got overvalued, crashed and caused a Great Depression. The true story is that monetary policy tried overzealously to stop the rise in stock prices. But the main effect of the tight monetary policy…was to slow the economy. The slowing economy, together with rising interest rates, was in turn a major factor in precipitating the stock market crash.’
The singular cause of the Great Depression of the 1930s, in Bernanke’s view, was that the Federal Reserve fell under ‘the control of a coterie of bubble poppers.’
Bernanke was merely reaffirming a well established consensus among economists, ranging all the way from John Maynard Keynes to Milton Friedman. In his A Treatise on Money, Keynes said ‘I attribute the slump of 1930 primarily to the deterrent effects on investment of the long period of dear money which preceded the stock market collapse and only secondarily to the collapse itself.’ Friedman’s 1963 A Monetary History of the United States also laid blame for the Great Depression squarely at the feet of the Fed and its attempt to become ‘an arbiter of security speculation or values.’
The US Fed’s attempts at managing asset prices in the late 1920s were mirrored in Germany, where Reichsbank President Hjalmar Schacht feared that capital was being diverted from ‘productive uses’ into a ‘Börsenblase’ (‘stock bubble’). Schacht’s view was that ‘nothing better could happen to us than it collapses.’ The subsequent Reichsbank-led credit tightening precipitated the ‘Black Friday’ crash in Berlin’s stock market on 13 May 1927. The subsequent economic downturn was a major factor in the demise of the Weimar Republic, with now well known consequences for Germany and the rest of the world.
The US economist John Taylor developed a rule which benchmarks the stance of monetary policy with respect to consumer price inflation and the level of real economic activity. According to Taylor’s rule, US monetary policy was too easy between 2003 and 2006. The Fed’s main concern between 2001 and 2003 was pre-empting the risk of consumer price deflation, which it rightly saw as a larger danger to the US economy than the emerging boom in housing and house prices.
If the Fed made a mistake, it was in not following the policy benchmarks established by Taylor. If the Fed is at all implicated in the current problems in financial markets, it is because of its failure to consistently target actual consumer price inflation, rather than any failure to manage asset price inflation.
The lesson from historical episodes, as well as the current crisis, is that monetary policy needs to be more rule-bound, not more discretionary. History shows that a discretionary monetary policy that targets asset prices leads to economic and social misery on a scale far worse than anything we have seen in the current crisis.
Dr Stephen Kirchner is a Research Fellow at the Centre for Independent Studies, he is speaking on Wednesday night at the CIS’ Crisis Commentary.
