As recently as 25 years ago, monetary stability in the US was based on the Federal Reserve System’s control of the quantity of money. Financial stability was ensured by the comprehensive regulations of the Glass-Steagall Act. Today, these regulations are gone and a great wave of innovations has changed the financial landscape. And we no longer know how one might define the “quantity of money” for control purposes.
In this new environment, price-level stability is supposed to be taken care of by inflation targeting while financial stability is supposed to take care of itself, given the many new ways of diversifying and trading risk that have evolved since deregulation.
Inflation targeting is an adaptive strategy keyed to movements of the inflation rate. If inflation rises, the central bank should counter it by raising the interest rate. The presumption is that if the inflation rate is low and steady, monetary policy is “just right”.
Acting on that presumption in a period during which consumer price index (CPI) inflation in the US was stabilized largely through the exchange rate policies of major trading partners, the Federal Reserve System kept its rate too low for too long. The result has been asset price inflation, high leverage ratios in the financial system and widespread deterioration of credit standards. This is the legacy with which markets and policymakers are now struggling.
Securitization and risk transfer instruments were supposed to have made the financial world a safer place. But although securitization dispersed risk away from the banks where it used to be concentrated, in the system as a whole, there is more of it, it is less transparent and we know less about how it is distributed.
Losses in the subprime mortgage market started to mount already in the fall of 2006, but it was only after some prominent funds failed in late June that the credit crisis became general as the asset-backed commercial paper and the interbank markets froze up. Suddenly, assets which had been eminently marketable at short notice yesterday had no ascertainable market value today in the total absence of buyers. Three months later, the panic that gripped Wall Street has eased, but much toil and trouble remain before the overall size of losses and their final distribution are worked out.
There has been much brave talk about the “real economy” still going strong as if finance were no more than froth on its surface. But if the economy has to go through a period of substantial de-leveraging, as seems more than plausible, a recession is inevitable. If everyone, on average, tried to buy less and sell more in order to reduce indebtedness, the result has to be excess supply of goods and services, falling prices and rising unemployment.
Beyond the immediate prospects, central banking doctrine needs to be reconsidered. What recent experience has now demonstrated is that a monetary policy which succeeds in keeping the CPI inflation rate on target may still do damage. But many adherents of inflation targeting have been adamant that central banks should not let themselves be led astray by asset prices since what is or is not a bubble cannot be known in advance of it actually popping. (Is deterioration in credit quality equally ambiguous?, one wonders. Or might ninja loans be at least a clue?) This attitude is strongly reinforced by political pressure on policymakers. When a bubble is inflating, all the institutions and individuals who see themselves getting rich will oppose any central bank attempt to deflate it—with no countervailing interest of political consequence on the other side. After the bubble bursts, however, the political pressures are all for the bank to pick up the pieces.
This political asymmetry is all the worse due to the economy’s asymmetric response to policy. It is easy to feed a bubble, but very hard to reflate it once it has burst. Greenspan managed to reflate after the dot-com bust, but Japan’s inability to do so for so many years after its double crash in 1990 is a more ominous example.
A further exacerbating factor is the cyclical asymmetrical response of the major financial institutions. Risk managers lose influence on the upswing and only regain it after a bust.
No big exogenous shock set the current crisis in motion. What this almost certainly means is that the occurrence of crises is an endogenous property of the world financial system as we have let it evolve over the last 20 years. The various asymmetric responses noted above would tend to impart this kind of behaviour.
The summer 2007 experience will induce some regulatory changes. But it is safe to assume they will be of marginal significance—which means we have other crises coming down the pike towards us.
Axel Leijonhufvud is professor emeritus in the department of economics, UCLA. This article has been republished with permission from VoxEU.org. Comment at email@example.com