Since the beginning of the last decade, I and many people like me have undergone something of a conversion experience regarding the role of the Federal Reserve in lancing asset bubbles before they grow too large. Once upon a time, I held fast to the notion that the Fed’s main job was safeguarding the economy against the ravages of inflation, but this notion is clearly too reductive, too narrow.
As early as 2002, The Economist was warning people of such a narrow view. In a survey on international finance published that year, the magazine cited the efforts of two British economists in debunking the idea that a central bank’s lone job is inflation:
“Messrs [Andrew] Smithers and [Stephen] Wright, having dispensed with market efficiency and established that asset bubbles are possible, next take issue with the Fed chairman’s belief that central bankers are supposed to control only inflation, not asset prices. They argue that the downside of a bubble bursting—possibly some combination of depression and deflation—far outweighs the cost of raising interest rates to stop the bubble forming in the first place.”
This was inflammatory stuff in 2002. In 2010, it’s perfectly benign, even acceptable. The problem, then as now, is wholly political. It comes back to taking away the proverbial punch bowl just as the economic party is getting started, which tends to piss off a lot of people. As The Economist argued, everyone agrees that too much inflation is a very bad thing for everybody; therefore, the Fed is not overly concerned with the politics of fighting inflation. When it exists, there is broad political support for getting it back under control. But if the Fed targets asset bubbles, whether they be soaring stock valuations or the market for mortgage-backed securities, the job becomes trickier. Everyone knows what hyperinflation looks like; asset bubbles, however, are in the eye of the beholder.
There may be plenty of argument concerning what constitutes a bubble, but nobody does much arguing once one has burst. People will say they “never saw it coming” or “who could’ve known.” But, more often, there are plenty of folks who see the bubbles as they form, but they are ignored because too many people are making far too much easy money during a bubble’s formation. In such a scenario, only the Fed has the power to referee the dispute and act accordingly.
The real argument today – at least, to my mind – is not whether it is possible to identify bubbles, but whether the Fed can act in a responsible and independent manner in order to head them off before they grow too large. In that same 2002 survey that I quoted from earlier, former Fed vice-chairman Alan Blinder was quoted as saying that “[f]or the US economy to go into a significant recession, never mind a depression, important policymakers would have to take leave of their senses.” Well, yeah. As we have all witnessed since 2007, that is not a far-fetched scenario.
These considerations are at the very center of U.S. economic policy in 2010. There exists a very vocal group of policymakers and pundits who see the current extended near-zero interest rate environment as providing the raw material for bubble formation. Writing for Forbes, Keith R. McCullough, Chief Executive Officer of Research Edge, an investment research firm, argues that the Fed needs to raise interest rates in order to stave off the next bubble and return to a more healthful balance between fixed-income and equity investments:
“This is where the Fed’s unscientific narrative is dead wrong: That we need more debt and credit to fix our debtor nation problem. That we silly people who save wouldn’t know what to do with a risk free rate of return if we ever see it again. That main street inflation with $81/barrel oil and $3.34/lbs copper is nowhere to be seen.
“In September of 2007, the Fed Funds Rate was 5.25%. We need to get at least half way back to that rate, over time, unless we want to become Japan. Savings build investment dollars. More investment dollars put into the hands of hard working American entrepreneurs is what builds the next Google or Nike. The Big Government Decade we just experienced failed. ‘Wide acceptance of an idea’ that we need to fear rates hikes ‘is not proof of its validity.’”
There is a lot of common sense in Mr. McCullough’s recommendation, but there are also some complicating factors that lead others to support current rate levels. Paul Krugman argues that current expectations for growth in 2010 are likely overstated, and even if one takes the rosiest prediction, it is still far below the typical post-recession growth curve. This dour outlook leads Mr. Krugman to assert that raising rates at this juncture would be tantamount to repeating the folly of the 1930s when we thought we had licked the Great Depression, only to experience prolonged economic malaise straight up to the beginning of World War Two.
I’m not sure I buy Mr. Krugman’s argument. If money and the people who earn it were mere inputs in some kind of grand video game, then maybe I could go along with his reasoning, but the money is real, and the people who earn it are real pissed, sensing that the vast redistribution at the heart of Krugmanian economics is a short-term fix at best. More importantly, we should pause now and ask whether we are getting into a position where near-zero rates and stimulus are becoming structurally necessary to economic growth, a kind of longer-term deferral of economic pain that we’re passing on to later generations. At the end of the day, if we are living beyond our means, throwing more money at the problem is not the answer. And that doesn’t even begin to touch upon the nasty boom-bust cycles inherent in the Fed’s policies thus far during the new century.
The fiber of booms and busts is woven into the very fabric of market capitalism, but I think we can all agree that the speculative manias of the Noughties were as much a product of post-9/11 Federal Reserve policy as anything else.
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