Hoisted from Archives:
Fragment of an Unfinished Ms.: Part II of an unfinished paper, "After the Bubble." The paper currently lacks Parts I, III, IV, V, and VI:
II. Aggressively Expansionary Monetary Policy and Macroeconomic Vulnerabilities:
Let us begin with a passage from Mussa (2004), "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" (Washington: Institute for International Economics: April 1), in which Michael Mussa writes about global financial imbalances:
Michael Mussa: ... Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada.... The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.
On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing.
A further concern related to the general monetary policy imbalance in the industrial countries is its effect on emerging market economies. Interest rate spreads for emerging market borrowers have contracted substantially and flows of new credit have increased. The boom in emerging market credit has not yet reached the frenzy of the first half of 1997, but it is headed in that direction. Another major series of emerging market financial crises (such as 1997-99) does not seem likely in the near term in view of the very low level of industrial country interest rates and the favorable global economic environment for emerging market countries. By 2005 or 2006, however, either upward movements in industrial country interest rates or deterioration of market perceptions of the economic and financial stability of some emerging market countries could trigger another round of crises.
Mussa is warning that the high asset prices produced by very low interest rates pose dangers that may turn out to be substantial. One way to read Mussa's warning is as a polite--a very polite--criticism of Alan Greenspan's self-praise of his own low interest-rate policy contained in Greenspan (2004), "Risk and Uncertainty in Monetary Policy" (Washington: Federal Reserve Board: January 3):
Alan Greenspan: Perhaps the greatest irony of the past decade is that... success against inflation... contributed to the stock price bubble .... Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve. It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization--the very outcomes we would be seeking to avoid.... The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.
Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."
During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September 2001, the federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years. We were able to be unusually aggressive in the initial stages of the recession of 2001 because both inflation and inflation expectations were low and stable. We thought we needed to be, and could be, forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided for the first time in forty years.
There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession--even milder than that of a decade earlier. As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability...
Greenspan is confident that raising interest rates and thus raising the unemployment rate during the bubble of the late 1990s would have been the wrong policy, and that aggressively lowering interest rates after the bubble was the right policy. Lowering interest rates cushioned falls in bond prices. Lowering interest rates made use of bond financing for investment more attractive. Lowering interest rates boosted bond and real estate prices, induced households to refinance, and so provided a powerful spur to consumption spending that largely offset the post-bubble fall in investment spending. In Greenspan's view, the aggressive lowering ofinterest rates was exactly the right thing to do in the aftermath of the bubble to shift spending from investment to consumption and so to keep the economy not far from full employment.
Mussa says: not so fast. Very low interest rates, coupled with assurances from high Federal Reserve officials that interest rates will stay very low for substantial periods of time, produce a situation in which the prices of long-duration assets--long-term bonds, growth stocks, and real estate--climb very high. What goes up may come down, and may come down rapidly. And should some class of asset prices come down rapidly and should it turn out that many debtors in the economy go bankrupt because their assets have lost value, serious financial crisis will result. The price of using exceptionally easy money to keep the collapse of the dot-com bubble from turning into a depression has been the creation of a three-fold vulnerability:
- If the assets the prices of which collapse when interest rates start to rise are emerging-market debt, then the memories of the 1990s and increasing risk will induce large-scale capital flight from the periphery to the core--an echo of the East Asian financial crises of 1997-1998.
- If the assets the prices of which threaten collapse when interest rates start to rise are domestic bond and real estate holdings that have been pushed to unsustainable levels by positive-feedback "bubble" buying, then the "monetary authority would... confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing" to keep real estate and bond prices from falling far and fast.
- "If monetary policy is tightened too much too soon" (presumably because of fears of positive-feedback "bubble" buying), the result may be a credit crunch and a recession--with no guarantee that a reversal of the monetary policy tightening will undue the effects of the credit crunch. I do not believe that many economists would say that Mussa's fears about the potential macroeconomic vulnerabilities created by the low interest-rate policy the Federal Reserve has pursued since the end of the dot-com bubble are unreasonable. (Few, however, carry their alarm to the degree that Stephen Roach of Morgan Stanley does.) And Mussa expresses them in a coherent language--one in which sustained rises in asset prices induce positive-feedback trading that "bubbles" prices above fundamentals, one in which what goes up comes down rapidly, one in which large sudden falls in asset prices produce chains of bankruptcy and raise risk and default premia enough to threaten to cause deep recessions. The language has echoes of the great Charles P. Kindleberger's (1978) Manias, Panics, and Crashes (New York: Basic Books), and of earlier writings about the consequences of excessive money-printing: "inflation, revulsion, and discredit."
But what Mussa's assessment of risks lacks is a model. And without a model, we have a hard time assessing his argument. Alan Greenspan frightened away the Evil Depression Fairy in 2000-2002 by promising not that he would let the Evil Fairy marry his daughter but by promising high asset prices--unsustainably high asset prices--for a while. Whether this was a good trade or not depends on the relative values of the risks avoided and the risks accepted. And to evaluate this requires a model of some sort.
Alan Greenspan (2004), "Risk and Uncertainty in Monetary Policy" (Washington: Federal Reserve Board: January 3).
Michael Mussa (2004), "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" (Washington: Institute for International Economics: April 1)