Preventing the Depression of 2009 31 comments
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Roger Farmer says the Fed needs to target an asset price index "to prevent bubbles and crashes":
How to prevent the Great Depression of 2009, by Roger E.A Farmer, Financial Times: ...Since world war two, economic policy in most western democracies has been based on Keynesian economics. But although policy makers still rely on Keynes’ ideas, academics gave up on his theories 40 years ago and went back to classical economics... The result has been 40 years of disconnect in which policy makers are tinkering with the engine without a manual. ...
Classical economists argue that falling wages will restore equilibrium; but this is based on the belief that the labour market works like an auction in which employment is determined by demand and supply.
It ignores the very real frictions involved in searching for a job by both households and firms that can lead to many possible equilibrium employment levels just as Keynes argued in the General Theory. ...
So where do we go from here? The only actor large enough to restore confidence in the US market is the US government. The current policy of quantitative easing by the Fed is a move in the right direction but it does not, as yet, go nearly far enough.
It is time for a greatly increased role for monetary policy through direct intervention of central banks in world stock markets to prevent bubbles and crashes. Central banks control interest rates by buying and selling securities on the open market.
A logical extension of this idea is to pick an indexed basket of securities: one candidate in the US might be the S&P 500, and to control its price by buying and selling blocks of shares on the open market.
Even the credible announcement that a policy of this kind was being considered should be enough to boost the markets and restore consumer and investor confidence in the real economy.
As I've noted many times, most recently here, I am also warming up to the idea of having the Fed target an asset price index in addition to inflation and unemployment.
But there are lots of questions to be answered first. What growth rate in the stock price index should we target? Should it be 8%? Lower? Higher? What is the correct time frame? Day to day fluctuations are quite volatile, we wouldn't want to react to every movement in the index, so how do we come up with a core measure that gives us an indication of the long-run trend in stock prices? Does value weighting, as in the S&P 500, give the optimal index, or would some other weighting scheme do better? Do we only include financial assets, or should other asset prices such as housing price index also be targeted? If so, how would we do that? When targets are in conflict, how much weight should deviations of the asset price index from its target value be given relative to deviations of inflation and output from their target values? Will it still be true that it is optimal for the Fed to react by raising the federal funds rate more than one to one in response to changes in inflation? How will adding another source of variation to the federal funds rate affect its smoothness?
We don't fully understand why interest rate smoothing is an important component of the Taylor rule, but it does seem to be important, so how will this change affect smoothness (it depends upon how the coefficients in the Taylor rule are adjusted after the new piece is added)?
And that's just a few of the questions, I'm sure I've overlooked many more (and please feel free to fill in the missing pieces in comments). Thus, while I certainly think this is a fruitful area to investigate, particularly in light of recent experience with the housing and stock price bubbles, we have more thinking to do and more regressions to run before we are ready to implement this kind of policy.
Finally, even with theoretical and empirical support, I'd be wary that asset price targeting alone will be enough to prevent problems in asset markets from developing in the future. Asset price targeting is a complement to other measures such as regulatory and enforcement changes, not a substitute, and I think it would be a mistake to believe simply twiddling with the policy rule will be enough to avoid another financial market meltdown that threatens the wider economy.
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This article has 31 comments:
Your article brings to mind a fleeting question I haven't really focussed on.
Can policy actions to avoid a depression actually take a situation which might have been a category 1 or 2 recession (using hurricane terms) and turn it into a category 3 or 4? How can it be determined which policy changes are constructive and which have the potential to aggravate the problems?
Considering these questions (which I doubt have definitive answers), your discussion of monetary policy trying to target stock index performance targets seems to me to be a very bad idea. Monetary policy should have commerce performance targets (employment, credit avialability, GDP, etc). Stock prices respond to these factors of commerce, they don't produce them. Trying to manage monetary policy by targeting dependent variables should not be considered.
Would you try to monitor colon cancer treatment by monitoring skin complexion?
If you're going to target an asset price (which is not in itself unreasonable), then target the price of gold, for Pete's sake! In other words, turn our fiat money into real money.
The only reason to do it would be to create an impression of wealth on the part of investors, so they would resume spending and regard their retirements as secure. Very easy, just make the S&P go up 8% every year, just like clockwork, same as it always did before these horrible things started happening. It would not work.
As John Lounsbury notes, the S&P index is a dependent variable.
You can envision manipulation of almost any single commodity with dire results to the underlying economy, but a basket of goods should be very difficult to manipulate.
The market is not the real economy!! The real economy is jobs, health care, homes, etc.... Companies are not stocks. Stocks are not companies. People need to really understand this fully before talking..
The market is not the real economy!! The real economy is jobs, health care, homes, etc.... Companies are not stocks. Stocks are not companies. People need to really understand this fully before talking..
Going into the future - such manipulation will surely take a toll on the value of the USD. If anything - I'd like to see creativity and energy put into creating some sort of a 'precious metal' backed currency...
The more things change the more they stay the same.
On Dec 30 04:07 PM John Lounsbury wrote:
> Frank Thoma - - -
>
> Your article brings to mind a fleeting question I haven't really
> focussed on.
>
> Can policy actions to avoid a depression actually take a situation
> which might have been a category 1 or 2 recession (using hurricane
> terms) and turn it into a category 3 or 4? How can it be determined
> which policy changes are constructive and which have the potential
> to aggravate the problems?
>
> Considering these questions (which I doubt have definitive answers),
> your discussion of monetary policy trying to target stock index performance
> targets seems to me to be a very bad idea. Monetary policy should
> have commerce performance targets (employment, credit avialability,
> GDP, etc). Stock prices respond to these factors of commerce, they
> don't produce them. Trying to manage monetary policy by targeting
> dependent variables should not be considered.
>
> Would you try to monitor colon cancer treatment by monitoring skin
> complexion?
The most effective way of using the government credibility is to guarantee private investors' capital investment into the financial markets for limited period of time with 3 to 5 years time frame - against company bankcrupcies. A 10 year par-value guarantee for capital may be offered to large private investors if the govt wanted to prevent solvent companies with liquidity problems from going down the bankcrupcy route.
This will immediately restore investor confidence that their capital deployment will not be in jeopardy for the next foreseeable future and reverse the massive technical and psychological momentum to the downside that the current markets are experiencing.
Likewise, with "real" money being injected into the economy, the spiraling lay-offs will be halted and consumers will start to have enough confidence to spend again as the economy recovers.
In the end; the government may not even need to spend a single cent when the economy returns back to normal function as those guarantees expire - an efficient and effective way of using the government credibility to halt investors' panic in times of extremely distressing financial market environment.
May be best to utilize this "last resort" action while confusion is still the norm rather than when total panic starts to set in.
Chaining the indexes to growth targets ensures that you'll never see an IPO of a game-changing firm like Google. Investors won't seek liquidity exits for high-growth startups if they think their growth prospects will be permanently curtailed.
Using monetary policy to smooth out the S&P 500's annual growth is a hugely expensive way to allocate scarce capital. Let's not go there.
As it presently stands, our governement does a mediocre job, at best, of controlling prices through monetary policy. The evidence behind this is constantly fluctuating prices and interest rates........part of which is the fact we our part of a global economic system and the policies of others will influence our domestic outcomes.
If the price of the SP500 is somehow controlled through government purchases and not the action of private investors, it would require that bureaucrats make the decisions that the global market makes today and all integrity of the market as we know it would be immediately lost. State control over share prices.
Business cycles perform useful functions and as long as we embrace democratic capitalism, the private market should be allowed to function freely. Much of the mess we are in today is a result of government intervention under the guise of social justice.
You don't want another index number out there that can be easily manipulated.
The best way to regulate the new financial system, is with low leverage and real organic growth! Abandon leverage higher than 10:1.
Appoint a SEC type organisation (private or government, even both) to ensure the market functions with integrity and responsibility.
Foremost, the US government should again publish the M3 numbers and integrate the oil and food prices into the core CPI numbers.
High volatility in oil and food prices will make sure that money expansion is controlled in an appropriate manner, offcourse with the right policies being enforced.
It seems problematic as a permanent mechanism. First, it would stifle innovation by quashing incentive. A company in the S&P wouldn't be properly rewarded for outperforming with growth or innovation or fiscal prudence. They would be valued on the same metric as the rest of the staid group. Worse, laggers could ride on inertia. Corporate lethargy would prevail. Investors would be turned off and the government would ultimately subsidize incompetence. Second, any US index does not exist in isolation. Better opportunities abroad would become apparent. Better domestic alternatives would even be available. Fourth, outperformers would be unfairly squeezed from raising capital in secondary offerings, etc.
There are undoubtedly many more negatives. It seems prima facie a bad idea. Nothing, however, seems off the table now. How to avoid bubbles and the ramifications? Some other way.
This has got to be one of the WORST ideas I've ever heard. Wouldn't this guarantee a mis-allocation of capital?
Given that the government now can sell 10 year bonds today at 2.1% yield - the dividend alone on S&P 500 is at 3.31% (ttm) will much more pay for the loan.
The profits from this intervention would be massive - a couple of years down the road. Investor psychology would be reversed and the govt. can control any bubble by selling the index when it feels the market is fully valued.
To me this is no different from currency market or interest rate manipulations which government do all the time.
This is also what sovereign wealth funds are doing.
Anyway, I agree with all the posters above. The idea is terrible. The Fed can't even manage interest rates without screwing up economic cycles even more (so much for smoothing) and the government is too inept even to pass a budget.
Seriously, who would ever think of giving tweedle dee and tweedle dum a giant cash fund with no strings attached to do whatever they want with it. Oops I guess we already did that. It's called the social security fund and TARP. And strangely, they are both tapped out of money. No surprise there.
Give them a trillion $ stock portfolio and they will do nothing but sell it. How will that help the market... Can you say Dow 3,000.
Yes we are headed into the economic toilet and if we had not voilated the consitution and created fiat currency neither this nor any 'remedies' would need consideration. The fed and our government as a whole is a wealth draining entity and must be eliminated from all markets entirely.
I can see it now...
"The economy is in need of increased stimulation via higher S&P levels"
code for:
"it's time to make everyone feel prosperous so that the incumbent President gets re-elected."
I can see it now...
"The economy is in need of increased stimulation via higher S&P levels"
code for:
"it's time to make everyone feel prosperous so that the incumbent President gets re-elected."
"It is time for a greatly increased role for monetary policy through direct
intervention of central banks in world stock markets to prevent bubbles
and crashes" "It is a great thing for governments that the people don't
think!" Mark, I think you recognize the first quote, just in case you have
not heard the second quote before, it was made by Adoplh Hitler some-
time before World War II! I think I suggested, in response to a previous
article of this sort you wrote several weeks ago, that you read Gold and
Economic Freedom by none other than Alan Greenspan (former student
of Austrian Economic philosophy and associate of Ayn Rand). In this
disertation Mr. Greenspan (before he joined the dark side like Anakan
Skywalker) railed against statists fears of maintaining the discipline of
the gold standard, the cause of the very bubbles and crashes you so
firmly believe can now be the saviour of our economic malaise! Your
unyielding pursuit of this opinion reminds me of another comment, this
by George Santyana.."the people who do not or will not learn from their
history are doomed to repeat it!". I won't bore you with suggested read-
ings any more, though Ludwig Von Mises (if you can bear the thought)
might open your mind to another world of economic reality!
Have a prosperous, and perhaps by some miracle, an enlightening NewYear!
EDT
Chicago, Illinois
The world will always suffer it's crooks. Transparency in markets will let market forces work as they should. Additional layers of government bureaucracy and regulation will serve little real world benefit. Allowing the same to do more economic "tweaking" is a recipe for disaster. But what the hell, it may already be too late.
On Dec 30 11:04 PM constructe wrote:
> Sovereign wealth funds exist because the government has too many
> foreign assets largely because of the US' hemorrhaging money annually
> through trade and budget deficits. I suppose the US could start a
> sovereign poverty fund where they use foreign debt to determine who
> gets the unwanted baby. Oh wait, I forgot, we already have that.
> It's called treasury auctions.
>
> Anyway, I agree with all the posters above. The idea is terrible.
> The Fed can't even manage interest rates without screwing up economic
> cycles even more (so much for smoothing) and the government is too
> inept even to pass a budget.
>
> Seriously, who would ever think of giving tweedle dee and tweedle
> dum a giant cash fund with no strings attached to do whatever they
> want with it. Oops I guess we already did that. It's called the social
> security fund and TARP. And strangely, they are both tapped out of
> money. No surprise there.
>
> Give them a trillion $ stock portfolio and they will do nothing but
> sell it. How will that help the market... Can you say Dow 3,000.