Stephen Roach is writing about a Wake-Up Call for Central Banking. Perhaps he has himself waken up from some kind of stupor when he suddenly turned bullish on the global economy right at the market top a couple weeks ago. Let’s tune in.
I worry increasingly that history will not treat the recent record of central banking kindly. Inflation may well have been conquered — a conclusion financial markets are actively debating again — but that was yesterday’s battle. Over the past six years, monetary authorities have turned the liquidity spigot wide open. This has given rise to an endless string of asset bubbles — from equities to bonds to property to risky assets (emerging markets and high-yield credit) to commodities. Central banks have ducked responsibility for this state of affairs. That could end up being a policy blunder of monumental proportions. A new approach to monetary policy is urgently needed.
By focusing solely on the inflation battle, there is now risk of losing a much bigger war. That’s what the profusion of asset bubbles is telling us, in my view. The great triumph of central banking rings increasingly hollow in today’s bubble-prone environment.
By consciously ignoring the perils of a mounting asset bubble — a stunning reversal, of course, from Alan Greenspan’s original warning of “irrational exuberance” in the stock market in December 1996 — the Fed became entrapped in the dreaded multi-bubble syndrome. Stressing that it had learned the lessons of Japan, the US central bank was aggressive in easing in the aftermath of the bursting of the equity bubble. A new Governor by the name of Ben Bernanke led the charge at the time in arguing that the US central bank should use every means possible to avoid an unwelcome post-bubble deflation — including, if necessary, “unconventional” measures aimed at targeting the yield curve, providing subsidized bank credit, and even pegging the dollar (see his 21 November 2002 speech, “Deflation: Making Sure “It” Doesn’t Happen Here”). With inflation low — and the risk of deflation actually rising at the time — the price-targeting Fed had no compunction about turning the liquidity spigot wide open. And so the miracle drug that was used as the cure for the first bubble created a dangerous addiction — systemic risk, in financial market parlance — that has fostered a string of asset bubbles. Unfortunately, that addiction has yet to be broken.
When inflation is low and a price-targeting central bank pushes nominal interest rates down to unusually low levels, there are new risks to confront — namely, asset bubbles. Central banks that let economies “rip” because inflation risks are minimal, are asking for trouble. That doesn’t mean monetary authorities should target asset prices. It does mean, however, that there are times when asset markets need to be taken into consideration in the setting of monetary policy. A low nominal interest rate regime is precisely one of those times.
America’s Federal Reserve is increasingly isolated in arguing that asset markets should be ignored in the setting of monetary policy. In fact, its new chairman is the academic high priest of inflation targeting — embracing an even tighter rules-based approach than his predecessor. Asset bubbles are, at best, an after-thought in a strict inflation-targeting regime. Therein lies the potential for a strategic policy blunder: The US central bank has yet to develop an exit strategy from the multi-bubble syndrome that the Fed, in its zeal for inflation targeting, has spawned. Moreover, as one bubble begets another, excess asset appreciation has become a substitute for income-based saving — forcing the US to import surplus saving from abroad in order to sustain economic growth. And, of course, the only way America can attract that capital is by running a massive current-account deficit. In other words, not only has the Fed’s approach given rise to a seemingly endless string of asset bubbles, but it has also played a major role in fostering global imbalances.
Central banks deserve great credit for waging a successful battle against inflation. To their credit, this war is never over — monetary authorities must always remain alert to the possibilities of a resurgence of inflation. But policy strategies have been surprisingly unprepared to cope with the pitfalls that emerge as economies near the hallowed ground of price stability. Nor have inflation-targeting monetary authorities shown themselves to be adaptable to changing circumstances, such as IT-enabled productivity enhancement and globalization. To the extent rules-bound central banks operate in a vacuum and fail to appreciate the impact of these powerful structural headwinds, they may be biased toward injecting too much liquidity into the system. The multi-bubble experience of the past six years is a wake-up call for central banks. A new approach to monetary policy is urgently needed.
I do not think that “Central banks deserve great credit for waging a successful battle against inflation” but at least most of the rest of what he had to say sounded more like the Roach I used to know. The reason there should be zero credit given to central banks for a successful battle against inflation is they did nothing to foster it. In fact they blew asset bubble after asset bubble so why should anyone give them credit for that?
Money supply exploded out of control under the Greeenspan Fed. It was only because of global wage arbitrage, outsourcing, and a productivity boom caused by the internet that inflation SEEMED low. Inflation was not low if one understands what inflation really is: growth in money supply an credit as discussed in Inflation: What the heck is it?.
Now Bernanke is even more intent on price targeting than was Greenspan. It is a policy doomed to failure as I mentioned in Inflation Monster Captured.
Sometimes money flows into houses and stock and bonds instead of goods and services. Sometimes productivity improvements mask inflation. Sometimes falling commodity prices mask inflation. Of course I am talking about “real inflation” as measured by increases in money supply as opposed to hedonically adjusted price inflation as seen through the eyes of central bankers.
The last paragraph is exactly what made a fool out of Greenspan. In the mid-to-late
1990’s, “real inflation” (a rampant increase in money supply), was masked by
productivity improvements, falling oil prices, and falling prices of goods from Asia. Greenspan called it a “productivity miracle”. It was a “miracle” indeed. Rampant increases in money supply fueled the 2000 stock market bubble and spawned nonsensical talk about “new paradigms”. Then in sheer panic “after the bubble pops” adjustments that he likes to make, Greenspan refused to allow a recession run its course. Instead he slashed interest rates to 1%, fueling the biggest housing bubble the world has ever seen. Here we are three short years later now facing a “new paradigm” in housing, with debt levels far worse at both consumer and governmental levels.
Given that Bernanke is even more focused on prices than Greenspan was, Roach is right to be worried. Our economic policies are clearly broken and and the Fed and government spending are right at the heart of the mess. Both are to blame.
A new approach is certainly needed as there is now hell to pay for the horrid economic policies of the last 18 years.
I suggest the following.
1)Eliminate fractional reserve lending
2)Let the market set interest rates
3)Abolish the Fed
4)Rein in government spending
5)Return to the gold standard
Can this all happen at once? Of course not. It would probably plunge the US into an instant depression if it was tried. Furthermore, one can have sound money without a gold standard, gold just makes the enforcement easier(see Gold’s Honest Discipline). Fractional reserve lending can be curtailed over time as can government spending. One way or another, unsound economic practices and serial bubble blowing will be halted or the market will force it at the worst possible time. The wake-up call may be loudly ringing but the big fear is that both the Fed and Congress are deaf.
Mike Shedlock / Mish/