There are basically four ways to deal with the possibility of severe financial crises. First, you can just cross your fingers, hope such crises don’t happen very often, and live with the consequences when they do. Second, you can publicly insure and regulate your economy heavily in an attempt to minimize the risk and severity of such crises. Third, you can have your central bank monitor the fragility of general financial conditions and “take away the punch bowl” when it thinks conditions are in danger of becoming too fragile. Fourth, you can have your central bank target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate.
For most of the past 20 years, the first approach – supported by a liberal dose of optimism that was buttressed (in the US, anyhow) by the experience of several financial crises with only mild consequences – was in favor. It’s suddenly unpopular now that we have gone through a crisis with severe consequences.
The order of the day seems to be some combination of the second and third approaches. Congress wants to overhaul financial regulation, and the Fed is reconsidering its erstwhile rejection of the role of bubble-popper. I am by no means the world’s foremost opponent of government involvement in the economy, but I find myself rather uncomfortable with these approaches, for much the same reasons that such a minarchist might be.
Regulation is costly, and I am skeptical as to whether Congress is smart enough, or has the right motivation (or the right group dynamic), to produce a regulatory regime that will be successful in achieving the benefit (avoiding future severe financial crises) without imposing unduly large costs. Regulators are human, subject to blind spots, bouts of unwarranted optimism and pessimism, and the temptation to rationalize actions that benefit their own interests more than those of the public. Without denying that some aspects of our financial system have been under-regulated in recent years (particularly given the public’s direct financial interest via actual or implied insurance programs), I question whether regulatory reform will be a significant improvement. Some things that have been under-regulated will be regulated appropriately, no doubt, but some things that have been appropriately regulated will become over-regulated, and some things that have been under-regulated will remain so.
As to the punch bowl approach, my concerns are similar. Undoubtedly there have been times when the Fed – if it had seen that as part of its function – would have popped an incipient bubble and avoided a much larger pop in the future. But if the Fed considered itself to be in the bubble-popping business, it might well have popped some healthy expansions long before they began to pose severe systemic risk. In retrospect, we can all agree that the last phase of the 1990’s tech boom was “bubbly;” but overvaluation concerns were being raised long before it reached that phase. If Alan Greenspan had followed up immediately on his famous 1996 “irrational exuberance” remark by using monetary policy to beat down that exuberance, I dare say the cost to economic growth would not have merited the benefit to financial stability. And, as it happened, by the time things had gotten dangerously bubbly, a lot of his skepticism seemed to have disappeared. A bubble is mediated through the public consciousness and reaches its peak when normal skepticism has all but evaporated. Are central bankers somehow immune to that consciousness?
The only conservative approach to the possibility of financial crises – the only approach that minimizes the damage without relying on authorities to behave better or more presciently than they normally do behave – is the last of the four I mentioned: inflation. Of the four approaches, it’s probably the least popular right now, especially among those who consider themselves conservative. All alike, populists, traditionalists, and technocrats hold that inflation is bad, and that low inflation, once achieved (as it has been) is so precious that it must be not be risked, let alone intentionally tossed aside, for the sake of some imagined greater good. That attitude brings to my mind the perfectly cleaned and ordered living room in which nobody is allowed to sit, lest they mess it up again.
Low inflation does have its advantages, but economists have been hard pressed to come up with any big advantage. The typical economic argument would be that the disadvantages of low inflation are even smaller than the advantages. But in the light of recent experience, that argument no longer holds much water: the big disadvantage of a low inflation regime is that, by putting a floor on interest rates that is not far below the inflation rate, it ties the hands of monetary policy when responding to a severe financial crisis. Surely, to the 17 percent of the today’s broadly defined US labor force who are wishing vainly for full-time employment (not to mention the apparent majority of Americans with full-time jobs, who, according to polls, suddenly hate those jobs, probably because they’re being asked to do the additional work of those whom their employers can no longer afford to keep on payroll, or because they feel their own job security in jeopardy), that should seem rather a severe disadvantage!
Among the most well-informed of the most vocal advocates of a low-inflation regime, the advantage cited most vociferously is stability. Only by maintaining low inflation rates, we are told, can central banks instill confidence in their policies. Even just raise the unofficial target from 2% to 3%, and all Hell will break loose, because….well, if 3%, then why not 4%? and if 4%, why not 5%? and if 5%, why not 10%? and so on. It’s a variation on the old “slippery slope” argument: not that we would actually slide down such a slope (since most sophisticated economists wouldn’t want to be caught making a standard slippery slope argument), but that it would be hard to give credible assurances to the contrary. The idea, I think, is that unless you can maintain something that looks reasonably close to true price stability (0% inflation), nobody will know what to expect. (2% is apparently considered close enough to zero – essentially the highest you can go and still be “close enough” to zero – and some argue that, once we have fully accounted for quality improvements, changes in consumer choices, and other such distorting factors, a measured 2% is more-or-less the same as a true 0%.).
Some would also argue that, whatever the ideal might be, an expectation of 2% inflation (actually just above or just below, depending on which price index you use) is what we have, what has crystallized over the past 10-15 years, and that it is therefore the only inflation rate about which we can have stable expectations going forward. It’s much easier to have confidence in a well-established existing regime than in a new regime that has only just been announced. Of course, this argument relies on the premise that markets do in fact still have confidence in the 2% regime – a premise for which supporters present as evidence the average results of long-range inflation expectation surveys. I do not find such averages very convincing. More people than usual expect deflation, and more people than usual (compared to the last 10 years) expect high inflation. And even those who expect canonical low-but-positive inflation – as the most likely single outcome – are more worried than usual that their expectations may be wrong in one direction or the other. Confidence – in low, stable, positive inflation – is not what I am hearing or seeing. Or feeling.
But this is one of those situations where you thank your adversary for bringing up the most important issue. “Stability” is what we all want. And it is precisely the pursuit of stability – in the long run – that leads me to advocate higher inflation targets. Let me, for the moment, concede, for the sake of argument, that higher inflation targets today might increase uncertainty, and that this increase in uncertainty might damage the recovery more than the expectation of higher product prices would help. Even so, the world does not end when this recovery is complete. (I do rather fear, however, that the world may end before the recovery is complete, only because the world must end eventually, and – in the light of Japan’s experience – there is no guarantee that the recovery will ever be complete.) Let’s suppose that the “stable inflation” medicine proves fully effective, the economy makes a complete recovery, and growth resumes a normal path --- for a while. What will happen next time there is a severe financial crisis?
Let’s distinguish between financial stability and economic stability. Financial instability often – but not always – leads to economic instability. I recall from 1987 (when I was in my first year of graduate school) a certain episode of financial instability in the equity markets. It didn’t last long, but it was huge news for a couple of weeks. It did not induce economic instability: in fact, it turned out to be almost a complete non-event economically. By contrast, instability in credit markets, over the past couple of years, has induced the worst economic crisis most living Americans can remember. The financial crisis itself has been a particularly severe one, and it would not have been possible to avoid some economic impact. But surely we could have gotten off with a much milder recession (and a more robust recovery than we are likely to experience) if the Fed had been able to pursue conventional monetary policy more aggressively.
But the Fed’s hands were tied. The Fed dropped its federal funds rate target by 5 percentage points in the year and a half following the onset of the financial crisis, and that was as far as conventional monetary policy could go. If the inflation target had started out at 4% instead of 2%, and the federal funds rate had started out at 7.25% instead of 5.25%, the Fed would have had a lot more ammunition. Moreover, the market would have known that the Fed had more ammunition, and investors would have been more confident in the Fed’s ability to minimize the economic impact of the financial crisis, and this would have made financial instruments less risky and thereby ameliorated the financial crisis itself.
You may therefore add my name to the list of those who blame past Fed policies for the severity of the recent crisis – but not because the Fed allowed a bubble to develop. Quite the contrary. The Fed eventually popped the previous bubble – the tech bubble – not because it was a bubble but because the economy was nearing the overheating stage, and the inflation rate risked eventually rising back to levels of a decade earlier. In my opinion, the Fed was wrong to pop that bubble. The Fed should have let the economy overheat, for a while, and let the inflation rate rise. (Higher future product prices might, in fact, have turned out to justify stock valuations that proved to be, in the retrospect of the path actually taken, unreasonable: a bubble is a slippery thing.)
I’m not saying that anyone at the Fed made a mistake. Indeed, Alan Greenspan handled that episode quite a bit better than I (and most others) expected, and quite possibly better than any of us would have under the same circumstances. I haven’t changed my opinion on that point: the Maestro conducted a near-perfect performance; all the instruments were in tune with one another, they entered precisely on the right beats, at just the right tempo, with just the right amount of “personal touch.” But the whole performance was in the wrong key.
In real life, I don’t have perfect pitch, and if I were listening to the performance in my metaphor, I might not notice anything wrong. But experience can be a substitute for ability. I’ve heard Beethoven’s Ninth Symphony performed in D minor enough times that, if I heard an orchestra perform it in E minor, I probably would notice that it sounded too high. I have been skeptical of the low inflation consensus all along, but I won’t fault those who were playing in the wrong key in 1995 or 2000 or 2005. But after 2008, we have the necessary experience. We’ve heard, first hand, how bad it sounds when the vocal soloist has to strain to reach notes that were easy for him to sing from the original score.
Admittedly, his voice is not nearly as strained as my metaphor, so I will say it in plain English. A number of economists have suggested higher inflation targets as a way to strengthen the recovery. Conventionalists counter that such targets, once implemented, will be difficult or impossible to replace once they have fulfilled their promise. But now, of all times, we should be aware of just why we should never want to replace them. Low inflation is what got us into this mess. And yet the consensus among policymakers seems stronger than ever: “Low inflation is awesome!” Dude, it’s lame.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
Lost in translation
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