“All bubbles burst when risk aversion reaches its irreducible minimum,” former Fed chairman Alan Greenspan writes in a new paper—“The Crisis”—for the Brookings Institution. That minimum, he advises, arrives with “credit spreads approaching zero, though analysts’ ability to time the onset of deflation has proved illusive.”
Is the maestro rethinking his long-held stance that central banks shouldn’t try to address bubbles? Not necessarily, although he leaves room for debate. “Some bubbles burst without severe economic consequences, the dotcom boom and the rapid run-up of stock prices in the spring of 1987, for example,” he advises, adding:
Others burst with severe deflationary consequences. That class of bubbles, as Reinhart and Rogoff data demonstrate appears to be a function of the degree of debt leverage in the financial sector, particularly when the maturity of debt is less than the maturity of the assets it funds.
I very much doubt that in September 2008, had financial assets been funded
predominately by equity instead of debt, that the deflation of asset prices would have
fostered a default contagion much beyond that of the dotcom boom. It is instructive in
this regard that no hedge fund has defaulted on debt throughout the current crisis, despite
very large losses that often forced fund liquidation.
Greenspan is now open to more financial regulation, according to his views in the paper, although he continues to argue that the unusually low interest rates that he engineered at the Fed in 2002-2004 weren’t a mistake or a catalyst for the surge in markets. That’s a debatable perspective, to say the least, as a number of economists argue, including:
• “The subprime crisis has its origin in Greenspan’s low interest rate policy.”
“Subprime crisis: Greenspan’s Legacy,” by Tito Boeri and Luigi Guiso
• “The Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 25 basis point increase in August 2006.”
“Origins of the Financial Market Crisis of 2008,” by Anna J. Schwartz
Greenspan, however, doesn’t accept such criticism. “Could the breakdown that so devastated global financial markets have been prevented?” he asks in his new paper. No, he argues…
Given inappropriately low financial intermediary capital (i.e. excessive
leverage) and two decades of virtual unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt it.
Those economic conditions are the necessary, and likely the sufficient, conditions for the emergence of an income-producing asset bubble. To be sure, central banks have the capacity to break the back of any prospective cash flow that supports bubbly asset prices, but almost surely at the cost of a severe contraction of economic output, with indeterminate consequences. The downside of that tradeoff is open-ended.
But why not incremental tightening? There are no examples, to my knowledge, of a successful incremental defusing of a bubble that left prosperity in tact. Successful incremental tightening by central banks to gradually defuse a bubble requires a short-term feedback response.
But, policy impacts an economy with long and variable lags of as much as one to two years. How does the FOMC for example know in real time if its incremental ever greater tightening is impacting the economy at a pace the policy requires? How much in advance will it have to tighten to defuse the bubble without disabling the economy? But more relevantly, unless incremental Fed tightening significantly raises risk aversion (and long-term interest rates) or disables the economy enough to undercut the cash flow that supports the relevant asset prices, I see little prospect of success.
To be sure, there are no easy solutions when it comes to monetary policy in pre-crash periods. It’s quite easy to inject liquidity after a market decline and claim some degree of results. It’s far more of a gray area in the months and years before such events. Predicting the timing and magnitude of so-called bubbles, of course, is the problem. No one knows when, or if, such events are destiny until after the fact. That makes the idea of pre-emptive central banking policy challenging, to say the least.
Even so, that’s not an excuse for dismissing the central bank’s role in creating excess liquidity conditions that lead to economic imbalances. Central bankers are mortals, which means that their monetary prescriptions are less than perfect. Mistakes are inevitable. The question is whether we can learn from errors of the past? Maybe, although the first step is recognizing what went wrong.
Low interest rates alone weren’t the cause of the upheaval in 2008. But arguing the opposite extreme is no less misguided.