A Ben Bernanke speech earlier this week shows that central bankers remain as confused as ever about the best approach to responding to the emergence of asset price bubbles.
In the speech, to the annual meeting of the American Economic Association, the Federal Reserve Board chairman made a detailed response to the widespread criticism of the role of the Fed in the lengthy build up to the bubble in the US housing market that played such a major role in the global financial crisis.
There is a strong view that the Fed’s response to the 2001 tech wreck and the bursting of the dot-com bubble created the foundations for the sub-prime housing crisis that caused the global financial system to nearly implode. The Fed slashed US official rates from 6.25 per cent to one per cent in response to the 2001 recession and left them there, at their lowest levels for almost half a century, for four years.
At the time the US authorities were paranoid about the possibility that the US might experience deflation and something akin to the decade of economic winter the Japanese experienced in the 1990s. The prolonged period of zero or negative real interest rates, and massive fiscal deficits, are obvious macro factors in the creation of the bubble.
However, Bernanke doesn’t see them as primary factors and cited both the weak evidence linkage between loose monetary policies and asset bubbles and the complexity of using monetary policy to combat incipient bubbles to assign the blame for the latest bubble to poor regulation.
The arguments he used aren’t new. Central bankers have been talking about whether it would be appropriate or effective to use monetary policy pre-emptively to ‘lean’ against emerging bubbles since the aftermath of the recession of the early 1990s. That’s a discussion that became louder after the 2001 recession.
The problem with deploying monetary policy against bubbles is that it is such a crude tool. It doesn’t distinguish between bubbles and the real economy. Given the difficulty in identifying speculative bubbles until after the event, the lag between movement in official rates and their impact and the inevitable effect of significant rate rises on the real economy, attempts to use monetary policy tactically could do as much harm as good.
However, there is no doubt that prolonged periods of cheap credit lead to excessive risk taking and asset bubbles, which would tend to suggest that there is some role for conservative central banks in, if not preventing asset bubbles, at least helping to control the degree to which they swell.
The Reserve Bank’s conservatism – and stronger fiscal discipline – are seen as factors that helped protect the Australian economy from the kind of damage that has occurred in the US and Europe.
Bernanke is, however, right in assigning the major blame for the crisis on poor regulation. Again, the accolades the Australian Prudential Regulation Authority has received for its role in protecting the relatively solid state of the Australian financial system are useful as a counterpoint to what has occurred elsewhere.
The US regulatory system is complex, with multiple regulators and substantial potential for regulatory loop-holing and arbitrage. Plus the regulators themselves weren’t sufficiently conscious of the build-up in risks and concentrations within their institutions.
The Madoff experience, where a giant Ponzi scheme existed under the nose of the SEC for decades despite numerous warnings, could be regarded as a symptom of a wider malfunctioning of US regulation. The regulators got both the detail – the standards and practices of individual institutions – and the macro picture of rising leverage and risk and falling credit standards in the system wrong.
Bernanke is right to look to better regulation and stronger and more aggressive regulators as the primary protection against bubbles that pose systemic risk. There is a raft of new regulation in the global pipeline that will help reduce risk by lowering the leverage and improving the asset quality of those institutions that are of systemic significance.
But he was probably also correct in acknowledging that, despite its shortcomings and the practical problems associated with attempting to use it to ‘pop’ bubbles, there is a potential ‘supplementary’ role for monetary policy in reducing the threats to systemic stability created by bubbles.
One of the problems the US and Europe face at present is that the experience with monetary policy appears to demonstrate that long periods of stable pricing encourage the formation of bubbles. We are already seeing what many believe are bubbles developing in commodities and other asset classes because of the plethora of carry trades made attractive by the low short term rate environment.
The central banks can’t act against any developing bubbles because of the fragile state of their real economies.
That tends to support Bernanke’s arguments about the relative contributions of monetary policy and regulation to creating and responding to asset bubbles and places the onus on prudential supervisors and other regulators to be particularly vigilant and proactive even before they receive their new regulatory tools from the slow-moving global regulatory reform process.
This article first appeared on Business Spectator.
James was the editor and publisher of SmartCompany and LeadingCompany for five years. He is now the Australian Financial Review‘s companies & markets editor, and a former BRW editor.
