A Red Herring - By Doug Noland

"I’ll posit this evening that the entire issue of “central bankers vs. asset Bubbles” has become little more than A Red Herring. While it is as of yet too early in the unfolding financial and economic crisis for “consensus opinion” to have reached a similar conclusion, in reality contemporary monetary management can already be proclaimed an unmitigated failure. Cloaked in ideology and a flawed conceptual framework, the Greenspan/Bernanke Fed sat idly by as history’s greatest Credit inflation and myriad resulting Bubbles irreparably damaged the underlying structure of the U.S. Credit system and real economy (before going global). And while the Fed executes its latest round of post-asset Bubble “mop up,” precarious Credit Bubble dynamics are left to run similar roughshod through global financial and economic systems...

...

In no way do I believe “the ultimate purpose of a central bank” is to “foster economic prosperity,” and I certainly don’t expect any such grandiose mandates to survive in the post-Bubble environment. On many levels the notion that central bank policies are instrumental in creating prosperous economic conditions is problematic. For one, it grossly over promises in regard to the long-term benefits derived from government manipulation of interest-rates. Secondly, it virtually guarantees an accommodative policy regime and, inevitably, a strong inflationist bias. Thirdly, such a nebulous objective invites overly discretionary policymaking, along with an activist and experimental approach to monetary management. Fourthly, such an approach ensures that policymaking errors beget greater and compounding errors.

...

I was compelled to share some thoughts with respect to the “asset Bubble” debate. Actually, the subject matter is now little more than a distraction from more pressing Credit and pricing issues. Somewhat strangely, U.S. asset inflation is no longer the overriding concern. Instead, I ponder the ongoing issue of the current extraordinary financial backdrop: the global economy continues to operate in a unique environment without a functioning monetary regime. There is no mechanism – gold standard, Bretton Woods, or otherwise – to in anyway limit the quantity or quality of global financial claims inflation. It has become full-fledged unfettered “wildcat” finance unlike anything the world has ever experienced."


A Red Herring

By Doug Noland
May 16, 2008
Source

There was a flurry of media interest this week in the issue of central banking and asset Bubbles. There was Federal Reserve governor Frederic S. Mishkin’s speech yesterday, “How Should We Respond to Asset Price Bubbles?” This morning’s Wall Street Journal ran front-page with Justin Lahart’s article, “Bernanke’s Bubble Laboratory”. Also today, the Financial Times’ Krishna Guha penned an extensive piece “Troubled by Bubbles: central Bankers re-examining the hands-off approach,” one of several thoughtful FT pieces on the issue this week.

From Ms. Guha’s article: “In the aftermath of the dotcom crash in 2002, Alan Greenspan famously argued that central banks had little power to stop bubbles inflating and then bursting. All policymakers could do, said the then Federal Reserve chairman, was to ‘focus on policies to mitigate the fallout when it occurs’. His most vocal supporter was Ben Bernanke, then a Fed governor. As an academic, Mr Bernanke had championed the view that central banks should ignore asset prices except insofar as they affect forecasts for inflation and growth. ‘Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage,’ he said in 2002.”

Professor Mishkin’s speech offered at best only a flicker of hope that the Federal Reserve is moving away from failed Greenspan/Bernanke doctrine: “Financial history reveals the following typical chain of events: Because of either exuberant expectations about economic prospects or structural changes in financial markets, a credit boom begins, increasing the demand for some assets and thereby raising their prices. The rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses. At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets.”

I’ll say I was encouraged that the terminology “structural changes in financial markets,” “Credit booms,” and “feedback loops” were included in the initial paragraphs of Mishkin’s paper. This, presumably, would have had the analysis at least heading in the right direction. Yet the inclusion of Credit matters turned out to be little more than analytical palliative. Fed policymakers must now concede that underlying Credit conditions are an issue. Meanwhile, they appear content to take the tack that not all Bubbles are created equal; that some are more impacted by Credit than others; that some are associated with more financial system risk than others – and, at the end of the day, it’s impossible for the Fed to recognize and differentiate among them until after they have burst. Scant real progress has been made.

The conclusions from Professor Mishkin’s paper differ only subtly from previous doctrine: “First, not all asset price bubbles are alike. Asset price bubbles that are associated with credit booms present particular challenges, because their bursting can lead to episodes of financial instability that have damaging effects on the economy. Second, monetary policy should not try to prick possible asset price bubbles, even when they are of the variety that can contribute to financial instability. Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good. Instead, monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability… Third, because asset price bubbles can arise from market failures that lead to credit booms, regulation can help prevent feedback loops between asset price bubbles and credit provision. Our regulatory framework should be structured to address failures in information or market incentives that contribute to credit-driven bubbles.”

Such an “academic” approach will bear little fruit. Clearly, all the theorizing in the world will have no impact whatsoever on the burst technology and mortgage finance/housing Bubbles. There are, however, present-day issues of pressing vital concern. First of all, if a new regulatory approach is central to combating “episodes of financial instability”, I strongly suggest Professor Mishkin and the entire Bernanke Fed move immediately toward assuming GSE oversight (which they will avoid like the plague). Fannie, Freddie, and the FHLB have in total increased their “businesses” by over $900bn during the past year - and have been getting geared up to move full speed ahead. The GSE’s top regulator, commenting on CNBC back in March, stated that Fannie and Freddie “could do over $2.0 Trillion in business this year if the market needs that money.” That was a blaring warning that “regulation” will remain a major part of the problem.

I’ll posit this evening that the entire issue of “central bankers vs. asset Bubbles” has become little more than A Red Herring. While it is as of yet too early in the unfolding financial and economic crisis for “consensus opinion” to have reached a similar conclusion, in reality contemporary monetary management can already be proclaimed an unmitigated failure. Cloaked in ideology and a flawed conceptual framework, the Greenspan/Bernanke Fed sat idly by as history’s greatest Credit inflation and myriad resulting Bubbles irreparably damaged the underlying structure of the U.S. Credit system and real economy (before going global). And while the Fed executes its latest round of post-asset Bubble “mop up,” precarious Credit Bubble dynamics are left to run similar roughshod through global financial and economic systems. Better to downplay the asset Bubble issue for now, as we contemplate the nature of what will be a much altered post-Global Credit approach to central banking.

From Mishkin: “The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.”

In no way do I believe “the ultimate purpose of a central bank” is to “foster economic prosperity,” and I certainly don’t expect any such grandiose mandates to survive in the post-Bubble environment. On many levels the notion that central bank policies are instrumental in creating prosperous economic conditions is problematic. For one, it grossly over promises in regard to the long-term benefits derived from government manipulation of interest-rates. Secondly, it virtually guarantees an accommodative policy regime and, inevitably, a strong inflationist bias. Thirdly, such a nebulous objective invites overly discretionary policymaking, along with an activist and experimental approach to monetary management. Fourthly, such an approach ensures that policymaking errors beget greater and compounding errors.

From Mishkin: “After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative. …If monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small. More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.”

This passage, in particular, goes right to the heart of several key failings of current doctrine. The entire framework of ignoring asset Bubble when they are expanding and “mopping up” when they burst is a recipe for disastrous policy mistakes. And how was this not made unmistakably clear when the post-tech Bubble “mop up” stoked the fledgling Mortgage Finance and Housing Bubbles?

The problem with post-asset Bubble “accommodation” is that it specifically accommodates the very Credit infrastructure and related Monetary Processes that financed the preceding boom. It works to validate the present course of financial innovation (think “Wall Street securitizations,” “CDOs” and “carry trades”), while emboldening those at the cutting edge of risk-taking (think “leveraged speculating community”). To be sure, the same Wall Street Credit infrastructure that financed the tech Bubble was empowered to regroup, remerge, and aggressively expand to grossly over-finance much more expansive Credit and speculative booms in mortgage-related securitizations and housing. These days, powerful forces have been unleashed to over-finance the world.

Moreover, a commitment to aggressively cut rates in response to faltering asset Bubbles openly courts leveraged bond market speculation – a market dynamic that engenders artificially low market yields and exacerbates liquidity excess during the late-stage of asset bubbles (think bond market “conundrum”). The last thing a central bank should encourage is an entire industry dedicated to placing leveraged bets on the direction of Federal Reserve policy responses. A strong case can be made that U.S. Treasury and agency markets have become one massive Bubble.

The overriding flaw in the Greenspan/Bernanke approach has been to openly disregard Credit Bubble dynamics, in particular the increasingly profound role being played by Wall Street-backed finance in fueling Credit, market liquidity and speculative excesses. I believe The Ultimate Objective of a Central Bank is to Foster Monetary Stability in the broadest sense. In this regard, asset Bubbles should be viewed primarily as important indicators of some type of underlying Monetary Disorder. The key analytical focus must be on the underlying Credit and speculative dynamics fueling the asset price distortions – to better understand and rectify the source of “disorder” – and the earlier, the better.

The most dangerous policy approach is to further incentivize a system that has already demonstrated a proclivity for Credit and speculative excess – employment, output and “deflation” concerns notwithstanding. And never ever succumb to the temptation of using the leveraged speculators as a mechanism for stimulating the markets, the Credit system and the real economy. In this regard, contemporary finance has created an especially seductive trap for policymakers.

Greenspan, Bernanke, Mishkin and others repeatedly stress the inability of policymakers to recognize the existence of a Bubble until after it pops. It is my view that the entire notion of asset prices dictating monetary policy is flawed. The focus should instead be on the underlying sources of monetary fuel – the Credit growth and financial flows underpinning asset inflation and economic boom. In the case of the technology Bubble, the Fed should have been focused on the massive issuance of telecom junk debt and leveraged loans, the fledgling CDO and “structured Credit products” markets, NASDAQ and NYSE margin debt, derivative-related leveraging, and the enormous speculative flows over-financing the industry boom. The unfolding Mortgage Finance Bubble was conspicuous as early as 2002, with the onset of annual double-digit mortgage Credit growth and the rapid expansion of Wall Street mortgage-related securitizations and derivatives.

Central bankers can and should avoid being in the difficult position of having to respond directly to inflating asset markets. Instead, there must be carefully fashioned, communicated and administered “rules of the game”. To begin with, it is incumbent upon the Fed to clearly articulate to the public (and their elected officials) the overwhelming benefits of stable Credit and financial conditions. It must be conveyed that Credit and speculative excesses are destabilizing, fostering boom and bust dynamics and structural impairment. The public must come to appreciate that the effects of destabilizing Credit inflation come in many forms, including asset price inflation and Bubbles, Current Account Deficits, currency debasement, traditional consumer price inflation, and various distortions to underlying Financial and Economic Structures.

The Fed could then take a more active role in supervising and regulating system Credit within some pre-determined parameters – a “rules-based” as opposed to discretionary approach to monetary policymaking. For example, if total mortgage Credit exceeded some threshold, say 5% or 6% annualized, the Fed would have a mandate to move to restrain at the margin real estate lending (through various means, including increased reserve and capital requirements, higher interest rates and other punitive measures). Ditto for corporate and public sector debt growth. Specific margin lending limits would be enforced, and derivative and securities leveraging strategies would be closely monitored and regulated as necessary. Similarly, Credit growth beyond some predetermined threshold – albeit Bank Credit, broker/dealer liabilities, finance company borrowings, securitizations, etc. – would elicit a meaningful rebuke from monetary policy. The punchbowl would be closely guarded. There would be general parameters for major sectors, as well as for total system Credit growth.

I expect the idea of the Fed regulating Credit to be unappealing to many if not most. Consider it as food for thought. It is, after all, my strong belief that Unconstrained Credit and Speculation are the Bane of Free-Market Capitalism. For the Economic Sphere to remain generally unencumbered dictates a somewhat encumbered Financial Sphere. Unfortunately, radical and ill-conceived government intrusion into all aspect of our financial and economic lives will be the likely post-Bubble reality.

I was compelled to share some thoughts with respect to the “asset Bubble” debate. Actually, the subject matter is now little more than a distraction from more pressing Credit and pricing issues. Somewhat strangely, U.S. asset inflation is no longer the overriding concern. Instead, I ponder the ongoing issue of the current extraordinary financial backdrop: the global economy continues to operate in a unique environment without a functioning monetary regime. There is no mechanism – gold standard, Bretton Woods, or otherwise – to in anyway limit the quantity or quality of global financial claims inflation. It has become full-fledged unfettered “wildcat” finance unlike anything the world has ever experienced.

It is tempting to fixate on the asset Bubble issue. Yet a more pressing need is for the Federal Reserve and global central bankers to begin working towards the implementation of some type of functioning monetary “regime,” with the intention of returning some semblance of order to international finance. And similar to anticipating new U.S. central banking doctrine, one can bet confidently that change will not arrive ahead of “post-Bubble impetus”. No doubt about it, Heightened Monetary Disorder - the cost associated with the Fed’s U.S. Credit system bailout - is increasingly on display. Destabilizing speculation is returning with a vengeance, and it’s anything but limited to commodities markets.