Not only have we suffered a grave financial crisis over the past year-and-a-half; we also have a crisis in economic theory, particularly regarding the role of central banks. Back in the simpler world of 2007, the mission statement for central banks consisted of “inflation-targeting.” Their principle tool was interest rate policy.
Ben Bernanke, the current Fed president and former Princeton economics professor, has been a very strong advocate of inflation-targeting. He edited a tome on the subject in 2001 with Columbia’s Frederic Mishkin, who was a Fed governor from 2006, when Bernanke became president, until in 2008.
But there were a few dissenting voices before the financial crisis. They came mainly from the so-called Austrian School, named in honor of economists Ludwig von Mises and Friederich Hayek. They argued that by focusing only on inflation, defined as an increase in consumer prices, central banks risked conducting overly expansive monetary policies that could easily lead to asset price bubbles. The tech and housing bubbles of the past decade did not lower the Austrian School’s credibility, it must be said.
Before the housing bubble burst, central bankers, especially those of the Fed, countered the Austrians’ critique by saying that bubbles cannot be recognized until they burst. In the words of former Fed President Alan Greenspan, “If markets can’t recognize bubbles, neither can regulators.” But were they even looking, or did they simply ignore bubbles?
Reviewing Iceland’s economy in 2006, Mishkin wrote, “The analysis in our study suggests that although Iceland’s economy does have some imbalances that will eventually be reversed, financial fragility is currently not a problem, and the likelihood of a financial meltdown is low.” Was this analysis, in the clinical, scientific sense of the word, or was it wishful thinking? Iceland made news shortly after Mishkin’s rosy prognosis, as its banking system essentially failed.
Obviously, recent financial traumas have led central bankers to review their inflation-targeting paradigm. They now acknowledge that if the US housing bubble had been on the Fed’s radar, the catastrophes of 2008 might have been avoided. This is good to hear, but we think the Fed still has some troubles with bubbles.
In an op-ed piece in the Financial Times on 10 November entitled, “Not all bubbles present a risk to the economy,” Mishkin offered a glimpse into the Fed’s mindset perhaps. He distinguishes between two sorts of bubbles, the dangerous “credit boom” types and the benign “irrational exuberance” bubbles. The former can threaten the entire banking system so they demand action by central banks. But the latter should be free to swell until they burst, in Mishkin’s view, because they “do not present the same dangers to the economy as credit boom bubbles.” Finally, he argues, bubbles of exuberance should be tolerated because bursting them early, through policy actions or publicity, would lead “to much weaker economic growth than is warranted.”
Hence, grappling with the housing bubble would have been wise, but the tech bubble should not have been impeded. Mishkin thinks the tech bubble’s harmless nature explains why, when it burst, it “was only followed by a relatively mild recession.” Right.
We think this is a rather bold, even fantastical, interpretation of recent economic history. The US recession in 2000-2001 could, and probably should, have been much worse. The Fed only contained its consequences by inflating the mother of all credit bubbles, whose puncture plagues us today.
Mishkin’s dual (or double-bubble) approach leads him to conclude that “tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture.” I once read that history was “written by the winners.” We can only hope that policymakers and central bankers now see that controlling bubbles of all sorts is indeed an important mandate.
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