Preventing bubbles: regulation versus monetary policy.

• Author: Malpass, David

Over the years, there has been a lot to consider in the Federal Reserve's choices of monetary policy and their relationship to bubbles. My conclusion is that mistaken U.S. monetary policy, usually related to the Fed's indifference to the value of the dollar, has repeatedly caused harmful asset bubbles in the United States and abroad. Policy is again at risk with the Fed's imposition of near-zero interest rates and its decision to conduct large-scale asset purchases (termed "quantitative easing"). Regulatory policy has often been ineffective at identifying or addressing asset bubbles, especially those caused by Fed policy. The solution is a parallel track to improve monetary policy so that it provides a more stable dollar and fewer asset bubbles; and to strengthen regulatory policy so that it provides a more reliable base for growth-creating free markets.

In an October 1999 speech at the Cato Institute's Annual Monetary Conference, I criticized U.S. monetary policy for strengthening the dollar, driving gold and commodity prices down, and creating unsustainable deflationary pressures in developing countries. While the United States felt satisfied with the tech boom and low unemployment, the inflow of hot money driven by the strong and strengthening dollar was creating an artificial global capital allocation that ended in a bust and recession. I think the Fed should have sought a strong and stable dollar in the late 1990s, not a strengthening dollar, and encouraged stronger regulatory scrutiny in those financial markets where it perceived irrational exuberance. This approach would have resulted in faster, more balanced global growth.

Speaking again at Cato's Annual Monetary Conference in October 2004, I criticized the Fed's manipulation of the overnight interest rate (down to 1 percent over false concerns about deflation) and its policy of measured rate hikes what became a 0.25 percent limitation on rate hikes despite fast growth, rising inflation, a rapidly weakening dollar, and consequent booms in gold and commodity prices (Malpass 2005). The excess liquidity caused by the Fed's mistaken monetary policy soon turned into excess U.S. house construction and bubbles in real estate prices around the world. Again, a Fed policy choice of a strong and stable dollar as a guidepost for monetary policy would have allowed a better capital allocation.

Current circumstances require another strong challenge to the Fed's policy mix, The U.S. regulatory pendulum has swung from harmful laxness to barriers--tax, accounting, capital adequacy, and others--against normal commercial lending. Rather than fixing the regulatory problem implicit in the massive excess reserves banks are depositing at the Fed, the Fed is instead applying near-zero overnight interest rates and an average $75 billion per month in net balance sheet expansion through longer-term Treasury purchases.

This policy mix is creating many problems. Developing countries are suffering asset bubbles and inflation, the direct result of the Fed using excessive monetary policy rather than improved regulatory policy. The mistaken Fed monetary policy has induced a commodity price spike, costly to U.S. growth and working against the Fed's full employment mandate. Moreover, the Fed is causing currency volatility and providing concentrated profits for traders at the expense of broad global living standards. (1)

Misguided Monetary Policy

The Fed has often framed the asset bubble issue in terms of its role in identifying or controlling bubbles. Instead, it should adopt a monetary framework less prone to causing asset price volatility. The starting point for this is for the Fed to recognize dollar instability as a root cause of asset bubbles and busts in recent decades. Rather than ignoring the dollar, the Fed should monitor its value versus gold, commodities, and other currencies as a principal indicator of monetary policy, and seek a strong and stable dollar as a key condition for meeting the dual mandate of price stability and full employment.

Instead, the U.S. has shifted into a policy environment in which credit is being rationed by regulatory policy rather than price, a decidedly harmful monetary policy development. As a result, capital allocation is increasingly being determined by governments, regulators, and big corporations--a negative for long-term growth (Malpass 2009).

Financial leverage has shifted rapidly from the U.S. private sector to the Fed and Treasury, where borrowing costs are low. In the short run, this shift has been stabilizing. However, the near-zero Fed funds rate hurts savers and distorts capital flows. The Fed's buyback of Treasury notes and bonds leaves the taxpayer exposed to potential Fed losses exceeding its capital and to rollover risk due to the short maturity of the national debt.

In a letter I wrote to Fed Chairman Ben Bernanke (Malpass 2010), also signed by a large group of economists, we asked Chairman Bernanke to reconsider the Fed's asset purchases. The letter reads:

We believe the Federal Reserve's large-scale asset purchase plan (so-called quantitative easing) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the...