Daniel O'Connor | Integral Ventures, LLC
One of the best resources in tracking the credit dimension of the unfolding drama of stable instability is Doug Noland's excellent Credit Bubble Bulletin, in the latest issue of which he offers some choice excerpts from a panel discussion at a recent meeting of the Western Economic Association:
Question from the audience: “Professor (Milton) Friedman, do you think there’s a role for the Fed in identifying and managing asset price bubbles?
Friedman: “No.”
Questioner: “Could you elaborate?”
Dr. Friedman: “The role of the Fed is to preserve price stability. Period. And price stability in a broad aggregate – in a broad index. It should not be concerned with the asset markets as such, only as they effect indirectly – somehow – the price stability as a whole.”
Federal Reserve Bank of St. Louis President William Poole: “If I could just add to that. I absolutely agree. And one of the reasons I take that position – I’m really a hardliner on this. Let’s suppose that the Fed – as you would want with any good policy instrument – had perfect control over asset prices. I think it is incompatible with a market economy to have a government agency setting asset prices that are meant to allocate capital.”
Dr. Friedman: “Asset prices embody a real magnitude that is a real interest rate. And the Fed does not control the real interest rate.”
Setting aside for the moment the incredible implication that the Fed's current monetary policy is somehow consistent with a market economy, as well as the tedious fact that overall price inflation simply cannot be measured, let's continue with Noland's provocative commentary on the above discussion:
Contemporary, unrestrained, asset-based Wall Street Finance – operating without determined central banks ready to identify and hinder destabilizing asset inflation and asset Bubbles - is a recipe for “monetary” disaster. And it pains me to listen to Dr. Friedman still professing that price stability – measured by some broad index - is dependent upon the Fed actively managing the “money supply” (he stated so during the discussion). For systemic price stability – certainly including asset markets and the Current Account – the Federal Reserve must take an active role in regulating Credit expansions and system liquidity (“monetary” in the broadest meaning of “finance.”). Special attention must be given to monitoring and disciplining the marketplace in the event of heightened leveraging and speculating.
Admittedly, this would be a complex, radical and challenging departure from simply pegging short-term rates (or even “inflation targeting”), but one I believe is necessary. And Dr. Poole may believe that a Fed role in “controlling” asset markets is “incompatible with a market economy.” Yet, pegged interest rates, Fed assurances of abundant marketplace liquidity, and consequent inflating asset markets are these days dictating our system’s (gross mis)allocation of resources and “capital.” The current Monetary Disorder, and its perversion of system pricing mechanisms, is anathema to our Capitalistic system. Having asset markets as a prime focus of central bankers is not a “good policy instrument” – but an all-important process we’ll have to learn to live with. The Creation and Flow of (contemporary) Finance is no longer manageable under the current system.
The issue of asset price bubbles and the Federal Reserve’s role in identifying and managing them has become a particularly hot topic in recent months. As I addressed in Unprecedented Fundamentals, the Federal Reserve’s own study of the housing bubble hypothesis not only concluded that there is no such bubble but was silent on the Fed’s own role, indeed a central role, in facilitating the unprecedented fundamentals upon which the entire trend in housing prices is based. Thus, the framing of the above discussion—the Fed’s role in identifying and managing asset price bubbles—is problematic in that it ignores the Fed’s potential role in facilitating asset price bubbles prior to any such identification.
Recalling the basic architecture of stable instability--the competitive/cooperative dynamic between centralized intervention policies of the state and decentralized exchange strategies in the market--we can see that asset prices are influenced by both forces simultaneously. Just as important as these objective asset prices are the subjective strategies of investors and the subjective policies of bankers, which constitute the actionable knowledge base with which they design their actions, interpret their results, and learn from experience. Through this experience-based learning process, these asset prices then inform the gradual development of more effective investor strategies and monetary policies which, in turn, guide future actions by investors and bankers. These single-loop and double-loop learning processes are therefore essential to both the short-term performance and the long-term sustainability of asset prices.
This model also highlights another point that is typically overlooked in discussions like the one with Milton Friedman and William Poole. By definition, everything the central bankers say and do is designed to produce prices in assets and other goods that are different from those that would have resulted in the absence of the central bankers’ interventions. Think about it. There is no other reason for monetary policy but to effect some major change in the outcomes that would have otherwise resulted in a market economy without a centralized means of monetary inflation and credit creation. Therefore, if we can see that monetary policy has been inflationary for several years and we can see that certain asset prices have been rapidly appreciating in the wake of this policy and all the more so when increasingly-easy-to-acquire credit financing is being used to purchase these assets (e.g., housing, mortgages, and mortgage-backed securities), then it is not much of a leap in logic to conclude that the Fed is in part responsible for these asset prices, bubble or no bubble.
For example, in recent years, the Federal Reserve's inflationary monetary policy of lower short-term interest rates and lower reserve requirements for commercial lending has been met by similarly inflationary policies of some other central banks who, in order to support their respective export sectors, have attempted to stem the dollar's natural depreciation in relation to their own currencies by aggressively purchasing US dollar-denominated Treasury securities. The combination of these two opposing state interventions has produced lower-than-market interest rates which, in turn, have created valuable incentives for households to save less, borrow more, and consume more. To the extent that the value functions among householders have remained relatively stable, we can be sure that tens of millions of people have indeed saved less, borrowed more, and consumed more than they would have if the central banks had maintained policy neutrality.
At the same time, the central banks' inflationary monetary policies have resulted in lower-than-market costs of capital for businesses, which have therefore tended to raise more equity, borrow more debt, save more cash, and invest more in capital goods than they otherwise would have in the absence of these policies. We might also add home construction to this category of investment, whose production certainly seems to have increased as a result of the lower-than-market mortgage rates offered to builders and homeowners and the higher-than-market prices in mortgage-backed securities. These lower-than-market costs of capital have resulted in higher-than-market rates of appreciation in the prices of many assets--e.g., stocks, bonds, houses--which are often touted by government economists as the increasing savings balances that more than offset any downside associated with the decreasing saving rates. In other words, as long as wealthier householders see the value of their houses, stocks, bonds, and others assets rising, even in the absence of any new saving, then all householders as a group are considered to be relatively secure.
Overall, with more consumption and more investment, both funded with increasing degrees of leverage, we are seeing rates of US economic growth that are higher than what they would have been absent the monetary policy interventions. Furthermore, US economic growth appears to be increasing all the more so because of the growth in deficit-spending by the federal government, which has been fueled by lower interest rates for its own debt obligations as well as the seamless monetization of its budget deficits as a critical component of the Federal Reserve's inflationary monetary policy.
Such is the basic argument for the use of monetary and fiscal policies--increases in the supply of money and credit and increases in deficit-financed government spending--to drive economic growth, particularly in the midst of recession. So much the better if the US government can get foreign central banks to play along with them because of the US dollar's unique status as the leading global reserve currency.
The critical weakness in this proto-global-Keynesian policy, it seems to me, is that it relies on the distortion of market prices--the observable, measureable results of past market decisions--in order to incent market participants to make future market decisions that they would not have made if they could have based these decisions on valid market prices. Thus, as the model above suggests, monetary interventions in the credit dimension of asset markets can, through the distortion of asset prices, undermine even leveraged speculators’ efforts to learn from their market experiences and create more adaptive and sustainable market strategies.
If rising asset prices appear to confirm the validity of leveraged speculation while not disconfirming the validity of monetary inflation, thereby encouraging more of both, then we have a self-reinforcing dynamic, the limits to which are as psychological as they are financial. If this self-reinforcing dynamic between monetary inflation and leveraged speculation does not at least give central bankers and leading economists pause to reflect, then it would seem that there is very little learning of the double-loop variety to be expected in the near future. Absent a conscious second-order, frame-changing, double-loop revision in central bank policy or mass investor strategy, this self-reinforcing dynamic would likely build into a crisis sufficient to force such changes.
This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 Unported License.
Asset Price Bubbles: Monetary Inflation and Leveraged Speculation
See Also:
- Stable Instability
- Saving Ourselves
- Saving Themselves?
- Unprecedented Fundamentals
- Mutually Assured Disruption
- Debt Trap
- Temporal Conundrum
