Not so long ago the mantra of the Federal Reserve was that it lacked the ability to detect financial bubbles or pop them in an orderly way. Instead, the idea was that the Fed could try to ameliorate the busts that followed a boom.
“It was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity – the very outcome we would be seeking to avoid,” Alan Greenspan famously said. “Prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy.”
But now it seems the Fed’s poobahs are changing their tune. William Dudley—the former Goldman Sachs banker who is now at the head of the New York Fed—gave a speech on June 26th, the text of which was released while you were on the beach last Friday. In the speech Dudley renounces Greenspan’s theory of bubbles, which he describes as “the orthodoxy.” He takes the stance that asset bubbles aren’t actually that hard to identify, that the Fed has plenty of tools to deal with them, and to the extent it lacks tools it should develop them.
This is a breath taking claim about the ability of central banks to take control of markets. It seems as if the current crisis has emboldened certain central bankers. It’s easy to see how this could happen. A financial crisis arises, the Fed and Treasury go hyper-active to ameliorate its consequences, and its bureaucrats become impressed by their own power. What’s more, the faith of many that the Fed has the power to end our recession early or revive depressed markets easily leads to the corollary idea that Fed should be effective in preventing unsustainable booms. If the Fed can kill a runaway Bear, why can’t it kill a runaway Bull?
Is Dudley right? He doesn’t make much of an argument for his position. Rather, he just asserts it. But the question of how effective the Fed can be in regulating, preventing, popping and ameliorating the bursts of asset bubbles is too important to be left to such quick talk. For one thing, it will have a policy outcome when it comes to how much power the Fed should have a systemic regulator. For another, it will have consequences about how much security and stability investors should expect from markets governed by a “macro-prudential” regulator.
Bob Teitleman, the editor in chief of The Deal, says that even if the Fed had the competence to detect bubbles and smart-bomb them, it would never get away with exercising this power.
Does Dudley believe that the Fed is immune from tendencies of the larger culture, even if it can mount the necessary technical assault on bubbles? And even if that’s so, the Fed will be under the thumb of a Congress and White House that is clearly not technically proficient (that’s kind) and more attuned to the wackiness and waywardness of the broader culture. The process of bursting financial bubbles begins with technical judgments, which remain murky; but they end with politics. After all, there is simply no way for a central bank to prove that it avoided Armageddon. The key, in a sense, is not the ability of economists to forecast (which we should be sceptical about), it’s the maturity of the political class to accept that such wisdom exists. Right now, Congress can’t even decide if we’re heading for inflation or deflation, that we have too much stimulus or too little. How would Congress ever accept Fed intervention in a booming economy?
Simon Johnson at Baseline Scenario is also a sceptic. He notes, for instance, that we have yet to see an example of a regulator finding a bubble and popping it. What’s more, aiming at this new goal might distract us from ones we are more likely to actually achieve.
“You cannot stop the tide and you cannot prevent financial crises. But you can limit the cost of those crises if your biggest players are small enough to fail,” Johnson wrote.
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