For the second time in recent days The Wall Street Journal’s editorial page suggests that the recent turmoil in credit markets is due to “the Federal Reserve’s willingness to keep money too easy for too long” during 2003-2005. This kind of reasoning leaves me scratching my head: There is simply no hard evidence to support it. The only telltale sign of when a central bank has been too easy is rising inflation [emphasis mine]. While it is true that the Fed’s preferred inflation gauge, the personal consumption expenditures price index excluding food and energy, crept a bit above 2% for a period of time, this is hardly an indication of profligate monetary policy.I have emphasized two propositions (in three statements) which I regard as highly problematic and indeed as the intellectual seed which has grown into the recent turmoils:
[...] The decline in the aggregate volatility of the macroeconomy has naturally lead to a decline in both risk premia and credit spreads. This in itself should not be a problem. However, it is also possible that the relatively long period of tranquility in the macroeconomy has lead to a sense of complacency in financial markets, which in turn has lead investors to fail to appropriately discount risk and lenders to not apply standards that are sufficiently tight [emphasis mine]. It is also possible that there has been abuse of the existing regulatory system, particularly involving mortgage lending. These kinds of factors play out once the markets are put under stress and only serve to magnify the turmoil, as has been the case recently.
Now, about monetary policy during 2003-2005: By keeping interest rates low in the absence of inflationary pressures, the Fed prudently insured against a Japan-style stagnation. It is not unreasonable to suggest, further, that this period provides an illustration of how the Fed has contributed to the Great Moderation. So, oddly enough, Fed policy may be relevant to current financial market volatility not because it was bad, but rather because it was good! [emphasis mine]
1. "The only telltale sign of when a central bank has been too easy is rising inflation:" This is the unfortunate legacy of monetarism, which is thus quite alive with Bernanke, Gertler and other policy-oriented economists who are usually not considered to be monetarists (because monetarism is commonly identified with policy control of money supply as opposed to the control of the rate of interest). According to this view, economic stability is ensured as long as price stability is given. Thus, moderate monetary expansion is unproblematic - or even necessary to avoid deflation - as long as the economy generates real output growth (the demand for money "measured" to be stable in the "never never land of long run equilibrium" - to say it with Rothbard). This interpretation of the role of money implies that the quantity of money has an equilibrium level (or an equilibrium growth path). This of course violates the ideas of Hume, Ricardo, Thornton, Cantillon, the very ideas which Friedman is supposed to have "restated." According to this classical view, any level of money suffices to accomodate any level of transactions (the true meaning of neutrality) and changes in the level of transactions can be accompanied with changes in the level of prices (the quantity theory of money as a theory of the price level). What is more important, however, is that the only source of additional nominal aggregate demand - demand beyond the level determined by Say's Law, i.e. by the real produce of an open economy plus net exports financed by real output produced abroad - is monetary expansion (more Mv = more money in circulation). Thus, since resources do not endogenously increase - the real forces remaining within the 'real' boundaries of scarcity - more money is competing for the same supply. While asset markets may turn bullish in the short and medim run, it is clear that as long as producitivty growth does not catch up some expectations have to be disappointed over time. A bearish market is the consequence of a bullish market which is the consequence of monetary expansion (changes in relative demand are not good candidates to cause a general wave of speculation). Because the supply of factors of production and their technological ability to generate outcome is independent of the ECB's decision-making (as long as unemployment of the bottleneck-factors is absent, that is in our case, unemployment of capital goods - not of labor) not all promises can be fullfilled. You cannot eat your cake or have it, too! This means that in contrast to Gertler's statement, it is not sufficient for economic stability to ensure "price stability" but rather that the low interest rate policy of the FED and the ECB (measured by nominal credit expansion beyond the accumulation of real net savings) is the very reason for the present turmoils on financial markets. In supplying enough liquidity to nurse the shift in liquidity preference of the banking system, the central banks only postpone the crises - making it probably worse - instead of allowing real forces to become visible; that is, to allow scarcity to enforce its creative destruction. Instead, we just boost moral hazard.
2. "However, it is also possible that the relatively long period of tranquility in the macroeconomy has lead to a sense of complacency in financial markets, which in turn has lead investors to fail to appropriately discount risk and lenders to not apply standards that are sufficiently tight. ... So, oddly enough, Fed policy may be relevant to current financial market volatility not because it was bad, but rather because it was good!" This is a remarkable statement. And it underlines my recent worries about the rise of ad hoc reasoning in economic theory (especially when it comes to financial market and here especially when it comes to the case of crises). Ok, if the economy is growing on a sound path, the FED (or the ECB) is doing a good job and everything is fine, why do actors on financial markets suddenly become nuts? Why, Mr. Gertler, do risk premia shrink beyond a reasonable level just because there is an absent of turmoil? Why do financial actors behave irrational? Just to claim that risk premia shrink beyond any reasonable level is simply manna drop!
