Guest post: Sebastian Mallaby responds to Ben Bernanke

Posted on November 15, 2016

In this guest post, Sebastian Mallaby discusses how his research into Alan Greenspan’s life and career informed his belief that central banks should consider financial stability at least as important as price stability. You may also want to listen to our podcast interview with Mallaby from last month.

Ben Bernanke, chairman of the Federal Reserve from 2006 to 2014, has written an extended comment on The Man Who Knew, my biography of Alan Greenspan. He is gracious and generous, saying the book is “highly recommended.” “This book is not just for Fed-watchers,” he writes; “anyone with an interest in postwar U.S. economic and political history will enjoy The Man Who Knew.”

However, Bernanke objects to some of my conclusions. This is not a surprise, since my book is skeptical of policies he supported during the latter Greenspan period.

First, I argue that, as a preeminent academic invited to present a paper at the Fed’s Jackson Hole Symposium in 1999, Bernanke encouraged the Fed’s embrace of an unannounced inflation target, which in turn discouraged the Fed from acting against asset bubbles.

Second, I demonstrate that, as a Fed governor in 2003, Bernanke persuaded Greenspan and the rest of the FOMC to experiment with forward guidance. My book argues that the Fed’s forward guidance gave Wall Street an unhealthy degree of assurance about the pace of tightening in 2004 and 2005, which in turn freed Wall Street to take on other types of risk, making an asset bubble more likely.

Today’s central bank consensus is still shaped by the positions Bernanke championed in the late Greenspan years, so my critique is also a critique of existing attitudes and policy. In my view, monetary policy in the lead up to 2008 was too focused on price stability and not focused enough on financial stability; and, given the mindset of today’s central bankers, I fear that the Fed would repeat this error if a serious asset bubble confronted it.

As Bernanke writes in his comments on my book, the debate on the late Greenspan period “matters for the lessons that future policymakers should take” from the crisis of 2008. While conceding that “Mallaby makes some interesting arguments,” Bernanke charges that my conclusions carry “some questionable implications for future policy.”

Bernanke is one of the most distinguished economists alive, and I disagree with him cautiously. But because I share his view that there are important policy issues at stake, I set out below the reasoning I developed while researching my Greenspan biography.

The Limits to Regulation

The first step toward the conclusions in my book concerns regulatory policy. If it were possible to rein in Wall Street’s excesses through supervision and regulation, there would be no need to deploy monetary policy. A regulatory approach to bubbles and excess leverage would be preferable because it would directly address the particular part of the financial industry that is behaving recklessly. Further, a regulatory approach would be preferable because it would liberate monetary policy to target inflation: it is better to reserve the interest-rate tool for pursuing a single goal if possible. For these reasons, both the Bernanke Fed and the Yellen Fed have decided that regulation and supervision should be the first line of defense against financial instability. Monetary policy will be deployed only as a last resort.

I agree with this approach in theory. But my reconstruction of events in the late Greenspan era has led me to doubt it in practice. What history tells us is that regulation and supervision of finance fail repeatedly, even when regulators are making a reasonable effort. Contrary to myth, Greenspan’s tenure is a case in point: the Fed did make some effort to rein in excess risks, even if in retrospect it should have gone further.

But Greenspan confronted two problems. First, some of the risk takers, notably the government-backed housing lenders, Fannie Mae and Freddie Mac, were “basically untouchable,” as Bernanke puts it. Second, effective policing of finance was frustrated by America’s balkanized regulatory machinery. “Regulatory fragmentation posed practical challenges,” Bernanke agrees. “A large fraction of dubious subprime loans was made by lenders not supervised by the Fed or other federal regulators.”

Even though he accepts some of my arguments about the limits to regulation, Bernanke thinks I overstate them. “It’s too strong to argue, as Mallaby does, that a meaningfully tougher regulatory policy was completely infeasible,” he writes. But I don’t wish to claim that tougher regulation was “completely” infeasible. What I do claim is that regulation could not have been a lot stronger. Given the scale of the 2008 meltdown, you have to argue that regulation could have done substantially more if you are going to maintain that it could have averted a crisis without reinforcement from monetary policy.

Looking to the future, I am afraid that regulation is not more likely to prevent crises than it used to be. Thanks to the post-2008 reforms, major US financial institutions have more capital and liquidity. But the problem of regulatory fragmentation remains, and supervisors still struggle to keep tabs on the risks that the financial sector loves creating.

In countries with less balkanized regulatory systems, there may be some chance of preemptive action against excess leverage and bubbles. But in the United States, the prospects for strong regulatory preemption look bleak—and have probably been weakened further by the deregulatory mood following the recent election.

The Monetary Dilemma

If regulation is unlikely to fight off future crises, this raises the difficult question of whether monetary policy should be used as an additional weapon. Given the enormous cost of 2008, it seems reasonable that policy makers should at least be open to this possibility. But most central bankers, and most academic observers of central banking, tend to resist this view. Because they are heavily invested in the inflation-targeting framework, they want monetary policy to focus single-mindedly on price stability. They therefore stick with the optimistic belief that regulation can take care of potential bubbles.

Usually, the argument against using monetary policy to combat bubbles has come in three parts. First, it is impossible to know in real time that you are in a bubble. Second, interest rates would have to be raised a lot if they are to make any difference to a bubble, and raising them a lot would inflict disproportionate damage on the real economy. Third, it is not essential to deflate bubbles, because the central bank can mitigate their cost by cleaning up after them.

In his comments on my book, Bernanke does not press the third claim—the painful aftermath of 2008 has made it harder to believe in the clean-up-afterward strategy. (Bernanke does argue that Greenspan thought he could clean up after bubbles, but since this observation relates to our understanding of Greenspan rather than our view of future policy, I will put this aside, noting only that my book acknowledges this point and that my difference with Bernanke here is subtle.)

So this leaves the first two claims—that it is impossible to know you are in a bubble, and that the cost/benefit to using monetary policy to let some air out of a bubble is negative.

Clearly these are serious arguments. Bubbles are not straight-forward to identify: recently, for example, the cyclically adjusted price earnings ratio, developed by the financial economists John Campbell and Robert Shiller, suggested that the US stock market was as overvalued as it was in 2007; but some argued that the comparison had been distorted by changes in accounting methods.

Yet the fact that bubbles are hard to diagnose does not mean that the Fed should never act against them. Indeed, today’s consensus accepts this point, because it holds that central banks should respond to bubbles with regulatory policy. Moreover, given how damaging a major bubble can be, the Fed might want to act against a suspected one, even without knowing for certain that the market really is in bubble territory.

In my study of the Greenspan period, I argue that the circumstances were right for the Fed to fight a bubble with higher interest rates on two occasions: during the tech bubble in 1999, and during the lead-up to the subprime bubble in 2004-2005. In both cases, the danger signs of financial exuberance were evident. In 1999, companies with no earnings were attracting absurd valuations. In 2004-2005, home prices were rising fast and mortgage underwriting standards were deteriorating sharply.

As I relate in my book, the Federal Open Market Committee discussed the risk of financial overheating in January 2004, and Fed staff economists visited Greenspan to warn him of a housing bubble in late 2004. None of this amounted to certainty about the existence of the bubble. But the warning signs were there, and the Fed was aware of them.

Of course, if the cost of raising interest rates to combat bubbles is extremely high, doing so without certain knowledge of a bubble’s existence might fail a cost/benefit test. This is the essence of Bernanke’s second point: as he writes in his comments on my book, “quantitative cost-benefit analyses of the potential use of monetary policy to tackle asset bubbles have tended to find that the cost (the direct effect of higher rates on employment and inflation) greatly exceeds the putative benefits (a possible reduction in the risk of a crisis).”

It is clearly true that the cost/benefit verdict on pre-emptive action against bubbles will sometimes be negative. In 2010 the Swedish central bank raised interest rates to dampen an escalation in household debt and then had to back-track because of the hit to jobs and output. But Sweden attempted to act against financial instability at a time when inflation was below target, unemployment was already high, and the euro crisis was raging—circumstances that ensured there was a steep price for tighter monetary policy.

My complaint about Greenspan—and my plea to future leaders of the Fed—is that very different circumstances may also arise: circumstances in which inflation is around target and employment is healthy, and yet asset markets are flashing danger signals. In such times, the Fed should act. I am not pretending it will be straight-forward to identify such times. I am saying the Fed should try to do so.

Bernanke’s position, on the other hand, is that using monetary policy to prick bubbles will be appropriate only in extremis. In his view, the Swedish case is not merely a cautionary tale; it points toward a rule, because a wide range of studies tend to the same conclusion that raising interest rates to squeeze bubbles will fail the cost/benefit test.

But there are two concerns about this claim. First, some credible studies do deliver a favorable cost/benefit verdict. Second, it may be a mistake to insist too firmly on a policy recommendation that derives from econometric models whose conclusions can only be suggestive.

For an example of a study that leaves open the door to anti-bubble action, consider a paper presented recently at the IMF by Francois Gourio, Anil Kashyap, and Jae Sim. The authors cite Bernanke’s influential work—the paper he presented with his coauthor, Mark Gertler, at the 1999 Jackson Hole symposium—and then attempt to go beyond it. By introducing the possibility of a large financial crisis—another 2008—into their model, they qualify Bernanke’s view: because this type of crisis involves a permanent reduction in total factor productivity and a one-off shock to the capital stock, it leads to a persistent loss in GDP, the avoidance of which passes the authors’ cost/benefit analysis. It is true that other recent research—notably a paper by Lars Svensson, cited by Bernanke in his comments on my book—points the other way. But the debate is not yet settled.

Given the difficulty of extracting clear policy prescriptions from dueling models, it is worth considering two simpler propositions.

The first is that the cost part of the cost/benefit analysis is hard to predict, because it is difficult to know how much the Fed might have to raise short-term interest rates in order to deflate a bubble. Sometimes successive hikes in short-term interest rates can fail to prick a bubble, as happened in late 2004 and 2005. On other occasions a quarter-point rate hike can have a large effect, as in February 1994, when a bubble in the bond market popped, causing huge losses for traders with big bets on bonds or mortgage securities. On still other occasions, the mere hint of a potential rate hike can bring down asset markets, even without the short-term policy rate budging: this happened in 2013, in the famous “taper tantrum,” when a bubble in emerging-market credit was punctured.

In the face of these varied experiences, some of which involved the Fed deflating bubbles even without intending to do so, all parties to this debate should confess to some uncertainty. The use of monetary policy to prick bubbles should not be ruled out based on claims that we know that the necessary tightening will be so extreme as to be prohibitive.

In his comments on my book, Bernanke stresses the experience starting in 2004, writing that “the tightening cycle that began in June 2004 was arguably the most aggressive of any since the early 1980s.” This buttresses his view that only really harsh monetary tightening can prick a bubble, since the post-2004 squeeze took more than two years to do so. But not only do other examples (1994, 2013) point in a different direction, as we have seen. The post-2004 tightening was less aggressive than Bernanke suggests, and therefore less helpful to his perspective.

This brings me to my second simple proposition. The post-2004 tightening was not actually as aggressive as it seems because of the communication strategy that went with it. Throughout this period, the Fed assured Wall Street that it would tighten at a “measured” pace. As a consequence, all kinds of banks and shadow banks felt safe in borrowing short and lending long, since they knew they would not be ambushed by a surprise hike in the cost of short-term funding. Thus reassured, Wall Street borrowed short-term money copiously, parking the cash in vehicles such as conduits and SIVs, and using it to buy longer-term securities, including mortgage securities. By unleashing this additional demand for subprime paper, the Fed’s communication strategy blunted the effect that its interest-rate hikes might otherwise have had in pricking the mortgage bubble.

Economists sometimes dismiss this logic as puzzling. After all, the Fed’s measured hikes in short-term interest rates were gradually raising the cost of borrowing short to lend long, reducing the profits in this trade; therefore, one might expect less of this trade to happen, leading to a fall in the price of bubbly long-term securities. But this objection misses the way that Wall Street traders think. Traders don’t just look at the profit in a given trade; they look at the risk-adjusted profit. If the profit in borrowing one short-term dollar and lending it out for ten years goes down, but meanwhile the risk in that trade has been reduced, the risk-adjusted profit may actually look more enticing. So it was in 2004-2005. Because the Fed’s forward guidance made the risks look small, Wall Street levered up and fueled the mortgage bubble.

Bernanke understands the significance of Fed communications better than almost anyone. Indeed, my book relates how he explained the power of communications to his Fed colleagues in 2003: he was a pioneer in the appreciation of this channel of monetary policy. But Bernanke’s insight about the power of Fed communications implies a problem with his position that bubbles cannot be pricked, except by prohibitively large hikes in interest rates.

If Fed signaling can guide long rates downward (and by definition bond markets upward), as Bernanke argued to his colleagues on the Federal Open Market Committee in 2003, then surely it follows that a different kind of Fed signaling can guide interest rates up and asset markets down when necessary. In 2004-2005, if the Fed’s forward guidance had communicated less predictably, it would have pricked the mortgage bubble earlier.

As I said at the outset, Bernanke’s comments on my book are very generous. As a scholar-practitioner of the first rank, he has made enormous contributions to the theory, history, and practice of macro-economics.

But, on this question of monetary policy and asset prices, I fear he may be wrong; or, at a minimum, I fear we do not know enough to be sure that his belief in monetary impotence is justified. The bubble that popped almost a decade ago has reverberations that we still feel—not just in our economy, but in our politics. Central banks should be ready to fend off another such disaster with all their tools, not just with their limited regulatory arsenal.

Related links:
Don’t clean — lean! — FT Alphaville

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