Tuesday, June 30, 2009

Not the Fed's fault (at least its monetary policy)

Brad Delong is making sense:
What I do know is that the way the issue is usually posed is wrong. People claim that Greenspan’s Fed “aggressively pushed interest rates below a natural level.” But what is the natural level? In the 1920’s, Swedish economist Knut Wicksell defined it as the interest rate at which, economy-wide, desired investment equals desired savings, implying no upward pressure on consumer prices, resource prices, or wages as aggregate demand outruns supply, and no downward pressure on these prices as supply exceeds demand.

On Wicksell’s definition — the best, and, in fact, the only definition I know of — the market interest rate was, if anything, above the natural interest rate in the early 2000’s: the threat was deflation, not accelerating inflation. The natural interest rate was low because, as the Fed’s current chairman Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency).
Exactly. Monetary theory explains how if the Fed keeps interest rates "unnaturally" low, we'll experience inflation, a general increase in the price level. It does not explain how unnaturally low interest rates can produce massive relative price distortions and mispricing of risk. In fact, as I've discussed, the "global savings glut" is not enough to explain these either, although at least it's a little more coherent—to my knowledge, blaming the Fed for "unnaturally" low rates that didn't produce any inflation is a simple contradiction in terms.

At times like these, I wonder whether I'm just confused, and I have to admit that it's a distinct possibility. Yet I simply cannot understand how anyone can blame the housing bubble and financial disaster on the Fed's monetary policy. A post from David Beckworth (via another post by Delong) that purports to establish that rates were unnaturally low, for instance, seems to assume that the "natural" real interest rate is endogenously determined within the US—by American preferences and macroeconomic variables—even when the effects of global capital on the interest rate have been discussed to exhaustion. And again, this is hardly relevant, because there was no general price inflation, and I know of no conception of "natural rate" that means "whatever rate interacts with confused and irrational investors' psychology to prevent a bubble in real asset prices."

Now we're at the main point: you can argue that the Fed should have raised rates artificially high as a contractionary policy to burst the housing bubble before it became too dangerous. But this is not a very "natural" policy on the Fed's part, and it's not clear that it is even a good approach. I enjoyed this comment from Robert Waldmann in the comments section of Delong's post:
I definitely go with 3 mistakes not 4 as no way am I ever going to be drier than Alan Greenspan. The point, I think, is that there were much better ways to control the bubble than to impose high unemployment. In particular Greenspan had much finer tools.

The FED has regulatory authority which it didn't use. Even a Randian lunatic who is opposed to regulation in principle could have done things with lower cost per benefit than drive up unemployment.

For example he could have said "there is a housing bubble. It will burst. Only a total fool would count on an endless rapid increase in the relative price of housing.

Or "There is irrational exuberance in the housing market"

Or people securitizing and trading mortgages are going to regret it (a prediction or a threat doesn't matter he's Alan Greenspan).
Implementing contractionary monetary policy and creating unnecessary unemployment is hardly some obvious measure that the Fed missed out of incompetence. It is a speculative, indirect intervention into the market, even if it seems wise in retrospect.

Although many blame-the-Fed commentators seem to think they're grounded in monetary theory, they actually seem to be relying on ad-hoc theorizing about the nature of asset price bubbles. Since we don't have a very good understanding of the dynamics behind bubbles, they could be right or wrong, and without more solid quantitative footing, it's impossible to do any real cost-benefit analysis weighing the costs of unemployment against possible abatement of the housing bubble. There's a lot of false certainty here.


Matthew Saroff said...

But we did experience inflation as a result of the low rates, only it didn't show up in the stats, because it was filtered out through the use of the "imputed rent" instead of house prices.

Matt Rognlie said...

Monetary economics tells us how keeping rates too low will cause the general price level to increase; insofar as "inflation" was only present in house prices (but not even the closely related imputed rent), it was a large shift in relative prices rather than a increase in prices in general, and I don't think any monetary models are capable of explaining how low rates can lead to such large relative price changes in a single segment of the economy.

For what it's worth, I think it's entirely appropriate to use imputed rent rather than house prices in the price index. House prices essentially represent a claim to imputed rents for the lifetime of the house. The price level today should reflect the cost of housing today, not the anticipated cost 20 years from now that is built into house prices.