Mishkin Defend Bubbles (and of Course, the Fed)

The press becomes more surreal with every passing day. If we didn’t all have a stake in the outcomes, this would make for great theater.

First we have the absurd spectacle of bankers claiming that they are doing God’s work. Great! Then they should be willing to do it for free. I don’t recall the Bible discussing Jesus getting eight or nine figure compensation (or what passed for it back then), and the Gautama Buddha, born a prince, gave up all the trappings of wealth.

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.

It was Mishkin who in January 2007, argued that:

that this concern about burst bubbles may be overstated. To begin with, the bursting of asset price bubbles often does not lead to financial instability…Japan’s experience is that the serious mistake for a central bank that is confronting a bubble is not failing to stop it but rather failing to respond fast enough after it has burst….

With a track record like that, should anyone take anything he says about bubbles seriously?

Mishkin also argued:

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…

Yves here. We have the counterexample of Ian MacFarlane, governor of the Reserve Bank of Australia, who set out to combat Australia’s housing bubble. He did so by beating up on the banks, frequently pointing out that housing prices had risen too far, too fast and probably did not represent a great investment, plus a couple of judicious rate hikes. Australia is generally credited with having done a much better job of contending with its housing bubble than any other country in the same fix.

By definition, a bubble is a massive price distortion in certain types of assets. That is already not a good thing. If you believe in markets, you believe in the value of price mechanisms because they lead to efficient allocation of goods and services and help channel investment funds to productive uses. At a minimum, bubbles are bad because they suck capital into seriously suboptimal uses at the expense of better ones. So ANY defense of bubbles has to be regarded with considerable skepticism. Bubbles are bad even when they fall short of the standard of wrecking an economy, which appears to be the base line Mishkin is using in his FT piece. He contends that bubbles that are not fueled by credit are not really that pernicious:

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. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

Yves here. While narrowly true, this is all a bit slippery. The Fed was worried enough about the dot-com bust to drop rates WELL below the level indicated by its usual approach, the Taylor Rule, and held them there for an exceptionally long time. If this was such a benign bust, why did the Fed engineer and maintain negative real yields for so long?

The 1987 crash is a peculiar case. Even though equities had risen to bubble territory, the crash was worse than it should have been thanks to program trading. Moreover, Mishkin bizarrely omits that there WAS a credit component, namely LBO lending, which had been at high levels prior to the crash, picked up again in 1988 and was at high levels in 1989. The LBO bubble did help fuel the equity price rise (I recall a report in 1987 attributing 75% of the appreciation that year to takeover speculation, and a proposed measure to tax highly levered transactions was one of the proximate causes of the crash, see the Brady Report for details) but that did not unwind till the end of 1989. For some reason, the banking crisis of 1990-1991 is always depicted as an S&L crisis when non-S&Ls (including GE Capital) were big holders of really horrid takeover loans and took significant balance sheet hits.

And the commodities runup of the first half of 2008 would fit in Mishkin’s typology of “not so bad” bubbles. Jim Hamilton thinks, by contrast, that the rise in oil prices was the detonator for the credit contraction, that higher gas prices pushed overstretched consumers over the brink. And the agricultural commodities price spike led to riots over high soyabean and grain prices.

But Mishkin reverts to the same arguments he used in January 2007:

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.

Yves here. This is pure and simple willful blindness. And his argument, that policymakers are incapable of recognizing bubbles is silly. Investors and speculators (crudely speaking) have tougher stomachs than analysts (and presumably policy makers). You need to be willing to take losses and many people are not wired to do that. Being able and wiling to play in markets every day takes certain personal attributes that go beyond analytical ability. Bubbles are extreme events, they are less difficult to recognize than day-to-day investment picks.

Moreover, Mishkin offers a straw man: that the only way to stanch an asset bubble in a particular market is via monetary policy, which is a blunt instrument. Now it is true that the only tool readily available to the Fed now is monetary policy. But the Fed was lobbying to act as macroprudential regulator. It seems very peculiar that, in this post-bubble carnage, it has not done much of anything to generate thought (staff papers, for a starter) on the issue of what tools in addition to monetary policy authorities need to have at hand to be able to attack bubbles in specific, but significant, markets. For starters, you can restrict leverage, put limits on types of trading that might favor purely speculative momentum traders, etc (you’d need to look into particular mechanism peculiar to the relevant markets to devise a surgical intervention).

Mishkin’s arguments are absurd, except they reflect the Fed’s complete unwillingness to take on this task. It is much easier to offer the excuse that you are incapable (and talk yourself into it), than deal with the bigger issue: that pricking an asset bubble is unpopular. As Macfarlane noted:

Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….

Yves again. What is truly disconcerting about Mishkin’s remarks is that, even though he is no longer at the Fed, they probably represent conventional wisdom there. And that means the officialdom has gained perilous little insight from this disaster. George Santayana warned about the consequences of failing to learn from history….