The Fed and the Possibility of Macroprudence

By Simon Johnson

Policymakers like to make particular kinds of statements at a “low attention” moment, e.g., right before a holiday weekend. This gets items onto the public record but ensures they do not get too much attention. And if you are asked about these substantive issues down the road, you can always say, “we told you this already, so it’s not now news” – usually this keeps things off the front page.

Released on July 3rd (a federal holiday), and buried inside the Washington Post on Saturday (p.A12): An important speech (from June 26th) by the New York Fed’s controversial President, William C. Dudley.

If the Fed is to become the system or any kind of “macroprudential” regulator, what would it do with that responsibility? This is a hot topic for Capitol Hill in coming weeks as various committees take on this topic in whole or part.

Dudley says that the Fed can pop or prevent asset bubbles from developing. This would represent a major change in the nature of American (and G7) central banking. It’s a huge statement – throwing the Greenspan years out of the door, without ceremony.

It’s also an attractive idea. But how will the Fed actually implement? Senior Fed officials in 2007 and 2008 were quite clear that there is no technology that would allow them to “sniff” bubbles accurately – and this was in the face of a housing bubble that, in retrospect, Dudley says was obvious.

Dudley is quiet on whether or not, for example, we have an emergent bubble in emerging markets today. Is there also an effective bubble in US Treasuries, as John Campbell has argued persuasively?

“Asset bubbles may not be that hard to identify,” Dudley argues. Fine, but it would help to know exactly the Fed would do this ex ante – not using the rear view mirror.

Of course, if the Fed can’t get better at spotting bubbles, the implication is that no one can. Which means that “macroprudential regulator” is just a slogan – a nice piece of what Lenin liked to call “agitprop”.

And if macroprudentially regulating is an illusion, what does that imply? There will be bubbles and there will be busts. Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are – or are perceived to be – “too big to fail”?

You cannot stop the tide and you cannot prevent financial crises. But you can limit the cost of those crises if your biggest players are small enough to fail.

Comments

[John Lounsbury:]

Simon - - -

As long as very large banks are allowed to play with OPM (other people's money - ours) macroregulation is unlikely to be effective. The primary mechanism for regulation is prudence induced because you are risking your own money. I'm with you on the need to restructure the financial system into units that can succeed or fail on their individual merits. We don't need a financial system. We need a system of independent financial institutions operating within a simple but clear set of regulations.

Jul 08 01:25 PM

[CautiousInv...:]

I'm not a student of economic bubbles but I would suspect that excess liquidity, leverage and speculation combine to form the grounds necessary for the creation of a bubble.

Rather than looking for bubbles, which occur ex post facto, policy makers should focus upon those ex ante conditions that give rise to bubbles.

Jul 08 02:17 PM

[Lilguy:]

The Fed has mis-focused its policy initiatives so far. Rather than trying to preserve the economic wellbeing of the United States, it has focused on sustaining the wellbeing--or at least the continuing existence--of the major investment banks. Moreover, since more or less stabilizing the financial sector, it has done nothing to restrain these same banks, the primary sources of our financial instability, from repeating the kind of folly that got us here in the first place.

The Fed is totally unsuitable as a candidate for national economic macroprudence. We'd do better with no one at all.

Jul 08 05:49 PM

[Moon Kil Woong:]

Tim Salmon introduced the bankslaughter. For the fed, I think you can call it econoslaughter (not to be confused with ecological anything, they don't save animals, not even humans). They have made a mess of the dollars value and the US economy for dacades now.

The Fed needs less power, auditing, and Congressional approval to engage in QE and any other form of balance sheet expansion. Furthermore, when they take on trillions in liability that inevitably fall on the taxpayers shoulders should they fail, they need approval and proper disclosure. When Congress recently asked them for a list of what bonds they bought they first said they didn't know and then refused to disclose it to them since I suppose they thought our elected leaders are a security risk.

Since the Fed is too big to fail, I suppose they can prove their ability first by managing themselves more prudently. I would dare to say their balance sheet and Fed backstop guarantees are one big bubble in themselves. As parents always say, if you can't manage yourself you have no business bossing other people around.

The Fed was the chief architect of the last bubble with low interest rates being the catalyst. Thus their existing power has the ability to slow or stop such bubbles, proving the Fed already fails at the very thing it is asking to regulate. And if it can regulate, isn't itself violating the public/private dividing line it always brings to mind whenever it feels threatened? You can't have your cake and eat it too (unless your Goldman Sacs).

Jul 10 11:57 PM