The Federal Reserve’s Lame Attempt To Defend Itself Against Bubble Creation
By James Bianco - November 10th, 2009, 12:30PM
The Federal Reserve’s Lame Attempt To Defend Itself Against Bubble Creation
- The Financial Times – Frederic Mishkin: Not all bubbles present a risk to the economy
There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no. Are potential asset-price bubbles always dangerous? Asset-price bubbles can be separated into two categories. The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues. … The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. … But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.
Comment
Back in Janaury 2007, Mishkin gave us this:
To begin with, the bursting of asset price bubbles often does not lead to financial instability….
There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability….
House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value ratio for residential mortgages is usually substantially below 1...
Hence, declines in home prices are far less likely to cause losses to financial institutions…
Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble.Despite the clear dangers from asset price bubbles, the question remains as to whether central banks should do anything about them….
A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets…
A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed…
A third assumption needed to justify a special focus on asset prices in the conduct of monetary policy is that a central bank actually knows the appropriate monetary policy to deflate a bubble.…Given the uncertainty about the effect of interest rates on bubbles, raising rates to deflate a bubble may do more harm than good.
Instead of apologizing for his completely wrong and destructive ideas of less than three years ago, Mishkin is now arguing that the Federal Reserve has it all figured out. Not only can they now identify a bubble, but Mishkin has decided that if we are having another bubble not to worry as it is not the bad kind.
Fred, didn’t you do enough damage three years ago? The world does not need another Federal Reserve official making stuff up to justify current policy.
- nakedcapitalism (blog) – Yves Smith: Mishkin Defend Bubbles (and of Course, the Fed)
Now for those who follow the markets, we have the Ministry of Truth in action on the comment pages of the Financial Times, in the form of today’s offering, “Not all bubbles present a risk to the economy,” by Frederic Mishkin. Somehow, that headline strikes me as trying to make the case, “Nuclear wars don’t have to be bad for you.” In other words, this appears to be yet another instance of Team Obama attempting policy by PR rather than (novel idea!) actually crafting sensible programs and sticking to them. The Fed has been operating fist in glove with the Treasury throughout the crisis; the idea that it is independent is a joke. The Fed is clearly involved in a concerted program to reflate distressed assets (most notably housing) that has spilled into just about every type of investment (and a few that have not traditionally been investments, namely commodities). The Fed had been trying to argue that asset prices were irrationally depressed (funny how they had no problem with market prices when many fund managers saw they were wildly elevated, when risk spreads were absurdly low, and there was abundant evidence of froth in the credit markets). Now plenty of central bankers outside the US have been worrying out loud about the bubble in progress (they are framing it officially as a future problem, but reading between the lines, it isn’t hard to infer that they are concerned that it is already under way). And what has the Treasury and Fed said? Nothing beyond pointing out that they have tools for mopping up excessive liquidity. So now we have former Fed governor Mishkin, curiously stepping up now to defend the officialdom. I was told by a well-connected reader after the bloggerfest at Treasury that Team Obama was in full court press mode, trying to curry goodwill with others to burnish the perception of its financial policies. It isn’t hard to imagine that Mishkin was asked to assist.
Comment
To reitierate, this Mishkin piece is an embarrassment to his reputation and is nothing but a lame attempt to defend current policy. Whatever the Federal Reserve/administration (no difference between the two anymore) offered him for this defense was probably not enough.
November 10th, 2009 at 12:44 pm
The Mishkin op-ed was shameful.
Claiming that this ongoing bubble is lacking in credit completely ignores the infinite credit provided directly by the Fed and indirectly by driving interest rates to zero by diverting savors money to super risky search for yield.
That a person with such poor intellect and common sense can be a professor and a FED governor is the best indication of the basic disintegration of meritocracy in this country.
Poor USA.
November 10th, 2009 at 1:58 pm
This is a very sad missive, but no different from those suggesting that we still enjoy the best health care system in the world, or that there is no problem with our system of higher education, or any of the multitude of institutions turned into cash cows for the administrative elite.
How pathetic.
November 10th, 2009 at 2:12 pm
What staggers me about Mishkin’s analysis is his ignoring of the link between asset prices and stocks through securitization. Sure, IBM might not be affected much by housing prices, but what all the REITs and other mortgage-based bonds and securities in the world?
I’m troubled.
Jeff
http://www.cerebellumblues.com
November 10th, 2009 at 3:21 pm
“the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets.”
well- i guess as long as the banks are ok-
that’s all that matters-
all other bubbles- well . . . who cares- as the bank’s balance sheets aren’t impacted
November 10th, 2009 at 4:05 pm
How about we just abolish the Fed and let the market set rates?
November 10th, 2009 at 4:09 pm
[...] The Big Picture, James Bianco calls Mishkin’s piece “a lame attempt” by the Fed “to defend itself against [...]
November 10th, 2009 at 4:56 pm
Instead of lamenting the government’s PR, why not actually break down the logic of the Mishkin opinion piece? I posted this earlier today in FT Alphaville’s Long Room:
The FT has an opinion piece by Frederic Mishkin today questioning whether we should be concerned about asset bubbles in the context of current everts. His conclusion wrt the US and Europe is: NO.
I disagree and wonder if others perceive his argument as valid. He appears to set up a false dichotomy, at least false in this instance. He distinguishes between a bubble generated from multiple credit overlays and one merely arising from ‘irrational exuberance.’ The former is dangerous because of the knock on effects; the latter not so as knock on effects do not exist or are minimal.
In my mind he seems to be assuming a closed system and a starting point of a ’steady state equilibrium.’ If one is in a closed system experiencing an equilibrium, then financial actors gravitating toward an asset class without borrowing must be selling something else to fund their activities. Prices will realign until there remains no marginal buyer of the appreciating asset at the expense of selling the depreciating asset. If the misalignment was truly pushed to bubble proportions, we would merely have a realignment of value and wealth with little dislocation when the bubble ‘bursts.’ The bubble only becomes worrisome if it arose from leverage which, when the bubble bursts, must be dissipated and may form a cascade of descending values as it unwinds.
A steady state equilibrium does not appear to be the current case. We are operating in what appears to be an overlevered state which is attempting to realign. Even a benign ‘irrational exuberance’ bubble here may generate knock on effects when it bursts. Furthermore, to assume the US and Europe are a closed system and thus impervious to bubbles elsewhere, say China, seems extremely nearsighted. It is not merely the size of the US that caused the worldwide contagion; it is the interconnectedness of the financial and economic systems as well. Over a decade ago we learned that even seemingly inconsequential economies such as Thailand could exert significant worldwide negative externalities when bubbles burst. China is not inconsequential, nor are some of the other potential sources of bubbles. The absence of an equilibrium and existence of ongoing deleveraging would make the impact of a burst leveraged bubble whatever the source seem even more consequential.
Finally, I think Mishkin misses another point. He believes we cannot be creating a leveraged bubble because we are deleveraging in the US and certain other countries. This misses the point that much, if not all or more, of the private sector attempt at deleveraging is being counteracted by massive public leveraging. This leverage in certain instances, think TALF, PPIP, and the Fed buying mortgages is directly countering private deleveraging and leaving the state of the markets far from truly repaired. More ominous, other bubbles may be created in other areas as some of the government induced liquidity seeks other avenues of return.
In all, I think Mishkin is far too sanguine.
November 10th, 2009 at 5:05 pm
What I find significant about the Mishkin essay is that he wrote it. Isn’t that basically a signal that the Fed wants a bubble? And how do savvy traders react to that fact?
November 10th, 2009 at 5:43 pm
DJackson
Nice breakdown of Mishkin’s piece. But, you give him far too much credit. First more background on the professor.
Mishkin was an advisor to Ireland where the banking system fared the worst. In May 2006 he penned a piece fo the Iceland Chamber of Commerce that was a good road map of how to do everything wrong and make you banking system blow up as much as possible during a financial crisis
http://www.zerohedge.com/article/mishkin-iceland-nothing-fed-here-dude
And as I noted above, in January 2007 he argued their was not housing or credit bubble. Further he said the Fed is incapable of spotting bubbles and if they could, they should not be in the job of pricking them. Today in the FT he now says it is not only easy to spot a bubble but they can be categorized into various types.
Let me be blunt. The FT article had no co-author and cited no academic or private sector research. It sourced no one else. In other words, he made all this up out of whole cloth, probably in an hour or two a few days ago.
So, thanks for the reasoned analysis. But you probably put more thought into your rebuttal than Mishkin but into writing it.
He is the Fed’s “useful idiot” and will say wahtever he is asked to say. Therefore, he does not deserve the kind of analysis and respect you afforded him.
November 11th, 2009 at 9:49 am
Jim,
After almost 30 years of dealing with bond salesmen, I definitely understand the concept of a shill. Having said that, he unfortunately has the status which enables him to use legitimate platforms such as the FT to spread his opinion. I personally believe it is more effective to dissect his case and show it to be empty of content than merely call him a shill. We have a better chance of gaining converts that way.