Thinking ahead of the next big crash.

AuthorBitros, George C.

In the aftermath of the unprecedented 2008 financial crisis, researchers of macroeconomics, finance, and political economy are showing renewed interest in the old but very significant question: Are central banks in large reserve currency democracies--in particular, the U.S. Federal Reserve--prone to creating asset bubbles and, if so, how is it possible to prevent the misuse of the banks' discretionary powers?

If one searched for guidance in the relevant literature, one would come across three main strands of thinking. The oldest stems from the views classical economists held and is expressed in the following slump criticism that David Ricardo (1809: III, 21-22) addressed to the Bank of England for the way it managed the quantity of banknotes:

By lessening the value of the property of so many persons, and that in any degree they pleased, it appeared to me that the Bank might involve many thousands in ruin. I wished, therefore, to call the attention of the public to the very dangerous power with which that body was entrusted; but I did not apprehend, any more than your correspondent, the signature of "A Friend to Bank Notes," that the issues of the Bank would involve us in the dangers of national bankruptcy. Ricardo was concerned that the Bank of England violated the principle of price stability and, by doing so, risked ruining many people and driving Britain to bankruptcy. Notice though that Ricardo did not appeal to experts for devising mechanisms to tame the power of the central bank, as specialized economists are doing in our times. He appealed to the public--the ultimate source of power in democracies--by stressing that if central banks are left unchecked, they have too much power and may use it with devastating consequences for the citizens and their countries.

The 2008 events in the United States affirmed once again the time-honored truth of Ricardo's intuition that controlling the power of central banks is an issue of political economy rather than monetary engineering, and it is precisely this realization that motivates the present article.

The second strand of thinking emanates from the Austrian theory of the business cycles that Ludwig von Mises (1936) and Friedrich A. Hayek (1939) proposed. (1) For them, there was no doubt that ruinous bubbles are always ignited and propagated by central banks. The sequence of events they envisioned starts with an increase in the quantity of money issued by the central bank. This, in turn, lowers the nominal interest rate below the rate that would be set by the time preferences of savers. Responding to the lower interest rate, entrepreneurs create a boom by reallocating investment toward long-lived and away from short-lived capital goods, because the former become more profitable than the latter. But since the time preferences of savers remain unchanged, the demand for the output of long-lived assets grows gradually short of its supply, and eventually it becomes clear that capital has been misallocated. The greater the monetary expansion, the longer the boom and the more serious the misallocation of capital becomes. Thus, there comes a time when suddenly a recession, or depression, breaks open and leads to liquidation not only of the inefficient and unprofitable businesses but also of the speculative investments in all sorts of financial stocks, bonds, and real estate. This theory explains what happened in the United States in 2008 quite well. But before looking into this issue in detail, a reference to the third strand of thinking is necessary.

This can be inferred from the analytical approach suggested by Adam Posen (2011) and presumes that it is impossible to say whether central banks create bubbles or not, because there is the following fundamental problem of knowledge. For central banks to self-control against creating bubbles, they must be able to: (1) identify precisely the relationship between the quantity of money and current prices, as well as prices that would be warranted by the fundamentals in key sectors in the economy; (2) construct reliable indicators that will warn sufficiently ahead which misalignments between these two sets of prices are dangerous; and (3) develop instruments that will permit quick and effective interventions whenever dangerous misalignments grow beyond certain safe limits. However, such knowledge does not exist at present and is unlikely to exist in the future. For this reason, central banks ought to adopt a minimalist approach to the aims they pursue and the instruments they use to achieve them. (2)

From the preceding it follows that the responses vary from, "yes," central banks do create dangerous asset bubbles, to "quite likely," depending on how they manage monetary policy and allow for the regulation of the banking industry, to "we do not know." As a result one might get confused or even discouraged by this lack of agreement among experts. But from a methodological standpoint, it offers a significant advantage because, by confronting the economic theories underlying the three responses with the facts, we may be able to come closer to a firm conclusion as to which is valid. Adopting this approach, I initially look at what happened in the United States in 2008 and employ the findings to assess the explanatory power of the three strands of thinking. From this assessment, it emerges that the Federal Open Market Committee (henceforth, "the Fed") created, or at least cooperated, in the creation of a real estate bubble, which, upon bursting in 2008, led the United States into a deep recession, unsettled the international financial system, and pushed weaker countries like Greece to the brink of bankruptcy.

Next, I discuss the ideas that have been proposed over the years to prevent central banks from misusing their power. Here I examine the literature on rules versus discretion in central banking, the influence it exercised in the conduct of Fed policy, and the present situation. The 2008 crash revealed that the institutional arrangements in place leave too much discretion to the Fed. Indeed, there are now high-level voices calling for the abolition of the Fed. Are such drastic proposals the solution? If not, how might institutional arrangements be overhauled to prevent the Fed from creating asset bubbles? If yes, what might be an alternative bubble neutral monetary regime? After addressing those questions, I conclude with a summary of the main findings and a few ideas for further research.

Determinants of the 2008 Crash

Before the 2008 collapse of the U.S. real estate market, there was another serious but relatively milder crisis in the 1980s, which emanated from the savings and loan (S&L) industry. In particular, toward the end of 1986, the rising rate of nonperforming loans of S&Ls was bankrupting the Federal Savings and Loan Insurance Corporation. The Reagan administration tried to secure the necessary funds to save it, but the Competitive Equality in Banking Act, which Congress passed in 1987, did not provide adequate funds and, even worse, compelled the Federal Home Loan Bank Board to continue pursuing regulatory forbearance, which implied allowing insolvent banking institutions to keep operating. The situation deteriorated rapidly. Losses in the S&L industry mounted and the collapse of the real estate market in the late 1980s exacerbated the problem. (3)

In 1991 Congress sought to take advantage of the lessons that had been learned from the S&L crisis by passing the Federal Deposit Insurance Corporation Improvement Act (FDICIA). Its provisions were designed to: (1) recapitalize the bank insurance fund by raising the ability of the Federal Deposit Insurance Corporation to borrow and to assess higher deposit insurance premiums until its reserves reached the level of 1.25 percent of insured deposits; (2) reform the deposit insurance and regulatory system so that taxpayer losses would be minimized; and (3) avoid regulatory forbearance and ensure quick action by regulators FDICIA was in the right direction as it reduced the scope of deposit insurance, strengthened regulators to deal with too-big-to-fail banks, and compelled them to intervene and resolve insolvent banking institutions quickly and decisively. But, with regard to the housing policies, FDICIA left the status quo intact and this, in combination with many other institutional arrangements and bank practices, proved once again its undoing in the years that followed.

What Happened

Congress has subsidized home ownership for generations. After the S&L real estate debacle, Congress started in the 1990s to channel its support mainly through two government-sponsored enterprises (GSEs): Fannie Mae and Freddie Mac. In particular, these two "banks" extended low-interest loans to American households that did not meet the standard criteria for obtaining mortgages through the normal banking channels. To secure the necessary funds, Fannie and Freddie issued securities backed by the mortgages on the houses they financed and sold them to domestic and international banks, insurance companies, and other financial institutions. Based on the guarantees of the federal government to these two GSEs, the value of subprime securities reached $4 trillion. Thus, when the rate of nonperforming housing loans increased unexpectedly in 2008, the value of houses and the mortgage-backed securities declined precipitously, causing widespread domestic and international turmoil. (4)

The crisis broke open with the bankruptcy of the giant financial firm Lehman Brothers and continued to worsen as major banks, insurance companies, and industrial concerns had to be saved with huge infusions of taxpayer money. Financial markets froze and banks stopped lending. Foreclosures of houses skyrocketed. Consumption decelerated as rising unemployment eroded personal incomes and consumers started to deleverage. Enterprises postponed investing as the uncertainty about the duration of the recession and the...

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