I am reading a great book by George Cooper, "The Origin of Financial Crises", which describes in detail his theses regarding central banks and their inherent reliance on the efficient market hypothesis. He criticizes central bank policy for being too lax as the economy heats up, and only aggressive as the economy enters recession. I haven't finished the book yet, but I believe that general conclusion will be that the Fed should use its powers to target asset price bubbles to offset the failure of the efficient market hypothesis and irrational investor behavior. Interesting.
In the book, he gives an example of the problem faced by central bankers reacting to "irrational" investor behavior. The following is an excerpt from a speech made by Jean Claude Trichet at the Mas Lecture in Singapore on June 8, 2005, "Asset price bubbles and monetary policy":
There is no consensus about the existence of asset price bubbles in the economics profession. Well reputed economists claim that even the most famous historical bubbles – e.g. the Dutch Tulip Mania from 1634 to 1637, the French Mississippi Bubble in 1719-20, the South Sea Bubble in the United Kingdom in 1720 as well as the worldwide new economy boom in the 1990s[2] – can be explained by fundamentally justified expectations about future returns on the respective underlying assets (or tulip bulbs). Thus, according to some authors, the observed price developments during the episodes that I have just mentioned – although exhibiting extremely large cycles – should not be classified as being excessive or irrational. For example, with regard to the new economy boom of the late 1990s it has been argued that uncertainty about future earnings prospects increases the share value of a company, especially in times of low risk premia.[3] This claim can be derived in a standard stock valuation model, where the price-dividend ratio is a convex function of the mean dividend growth rate. The mean dividend growth rate in turn depends obviously on future expected earnings of the company. Heightened uncertainty about future earnings will increase the price-dividend ratio. It has further been claimed that assuming apparently reasonable parameter values with regard to the discount rate, expected earnings growth and most importantly the variance of expected earnings growth, one can reproduce the NASDAQ valuation of the late 1990s and its volatility. There would thus be no reason to refer to a dotcom bubble. I do not mention this example because I believe the NASDAQ valuation of the late 1990s was not excessive. However, if one takes the narrow definition of a bubble very often used by these economic researchers,[4] there is a fundamental difficulty in calling an observed asset price boom a bubble: it must be proved that given the information available at the time of the boom, investors processed this information irrationally.
In order to target asset bubbles using monetary policy, one must be able to prove that the market
participants were no way the wiser, given market information at the time, and acting
irrationally. To me, this is exactly why targeting asset prices is difficult for the Federal Reserve, whose mandate is to promote a healthy economy through maximum sustainable employment, stable prices, and moderate long-term interest rates.
When targeting asset prices, the Fed must know that the underlying economic fundamentals have changed. All else equal, maximum sustainable employment and stable prices are no longer possible. One runs into the
quintessential problem with
macroeconomic data: heavy revisions.
A paper by
James Kahn at the Federal Reserve Bank of New York argues that the housing market is not an asset bubble, i.e., households and market participants acted rationally rather than
irrationally. Households and bankers could not have known that
productivity growth had markedly slowed toward its trend in the 2004-2007 years, and taking with it, expected income levels. Here is an excerpt from the conclusion (although the short read is
worth a look):
Housing market participants were slow to perceive the most recent decline in the rate of productivity growth because the data released through mid-2007 gave little indication of it. Subsequent revisions of the data made it clear that productivity had in fact begun to decelerate in 2004. Nevertheless, given the information available through much of the current decade, borrowers and lenders might reasonably have inferred that productivity growth remained strong—an inference that would encourage optimism about income prospects and hence higher expenditures on housing.
These findings, together with the previous discussion of the relationship between productivity growth, income, and housing prices, suggest the following scenario for the most recent housing cycle: With the resurgence in productivity that began in 1995, market participants began to see stronger income growth—not from working longer hours or having a second household income, but on a per hour basis. As individuals became more aware that this stronger growth was attributable to technological progress and that it might be sustainable, they grew more optimistic about their future income, and this optimism directly infl uenced their willingness to pay for housing. Such optimism would likely have been shared by lenders, who viewed mortgages as less risky insofar as income and house prices were growing more rapidly than before.
A decade later, however, signs emerged that the new period of high productivity growth would not be as long-lived as the post– World War II episode, which had lasted more than twenty-five years. As buyers and lenders began to recognize this, the same process that caused prices to rise and credit conditions to ease began to work in reverse. The expected income growth did not materialize and new buyers entering the market were less willing to pay high prices; thus, prices of houses purchased in recent years failed to grow as expected. Foreclosures began to increase as early as 2005, and lenders became more cautious.
Basically, household expected income had changed without the knowledge of the household. Therefore, it could be argued that there was no economic fundamental basis for which the central bank would have
known that an asset bubble was forming. To be sure, lending standards and
underwriting methods should have been regulated. The Fed could not have known that households would later be deemed irrational, and that economic
fundamentals had slipped out from under the economy until well after the bubble formed due to heavy revisions in the data.
Interesting stuff. Here is what
Bernanke said in a similarly titled speech to
Trichet's,
"Asset-Price "Bubbles" and Monetary Policy" on October 15, 2002:
So the problem of a bubble popping Fed is much tougher than just deciding whether or not a bubble exists; to follow this strategy, the Fed must also assess the portion of the increase in asset prices that is justified by fundamentals and the part that is not. In my view, somehow preventing the boom in stock prices between 1995 and 2000, if it could have been done, would have throttled a great deal of technological progress and sustainable growth in productivity and output.
It seems pretty clear, that it would take a rather robust methodology to change the Federal Reserve Act in order to mandate the targeting of asset prices. But who knows. It does seem hard to argue that
homebuilding, hence real economic activity, was not
bubble-ish. Starts remained around the 2 million mark between 2003-2006, while the Fed's incremental rate hikes did not commence until June 2004 (from 1%).
Rebecca Wilder
Read more...
The chart illustrates the bi-decade event that is the BEA's comprehensive revisions to the national income accounts (yes, nerdy me downloaded the saving rate series here in anticipation of the release). It is almost a rule that the saving rate is revised upward, and this time is no different. The saving rate has been revised to show a steady increase from an average of 1.7% in 2007 to 2.7% in 2008, and a surge to 4.6% in the first half of 2009. This looks large compared to the previous 2007-2009Q1 averages of 0.6%, 1.8%, and 4.3%, respectively.
