Jeremy Stein wants to spank all the little children

Free Exchange directed me to a recent speech by Jeremy Stein:

Imagine that it is 18 months from now, and that with interest rates still very low, each of the trends that I identified earlier has continued to build—to the point where we believe that there could be meaningful systemic implications. What, if any, policy measures should be contemplated? It is sometimes argued that in such circumstances, policymakers should follow what might be called a decoupling approach. That is, monetary policy should restrict its attention to the dual mandate goals of price stability and maximum employment, while the full battery of supervisory and regulatory tools should be used to safeguard financial stability…As we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability.

Let me offer three observations in support of this perspective. First, despite much recent progress, supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns. If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior…Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation—namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot. Third, in response to concerns about numbers of instruments, we have seen in recent years that the monetary policy toolkit consists of more than just a single instrument. We can do more than adjust the federal funds rate. By changing the composition of our asset holdings, as in our recently completed maturity extension program (MEP), we can influence not just the expected path of short rates, but also term premiums and the shape of the yield curve. Once we move away from the zero lower bound, this second instrument might continue to be helpful, not simply in providing accommodation, but also as a complement to other efforts on the financial stability front.

I wonder how much Mr. Stein knows about Fed policy during the 1920s.  The paper does not mention that 1929 was the last time the Fed tried to implement his proposed policy.  Indeed the paper does not discuss Fed policy during the 1920s—a very disturbing omission.   (Recall that I argued that only the very best monetary economists in the world should be allowed to serve on the FOMC.  Stein’s brilliant, but isn’t he a finance guy?)

During the 1920s NY Fed President Benjamin Strong was under a lot of pressure to “do something” about the stock market boom.  He resisted, arguing the Fed should focus on stabilizing prices and output. (Hmmm, what is the sum of the growth rate of prices and the growth rate in output?)  He died in August 1928, and the new leaders of the Fed finally had their chance.  They raised interest rates in late 1928, and then in early 1929, and then in mid-1929.  But it didn’t do any good.  Stocks kept soaring higher and higher.  And there’s a reason it didn’t do any good.  Stocks are very long lasting assets.  Investors care much more about the future performance of the economy than the current setting of very short term interest rates.  As long as the economy was booming and there is no inflation, why should stocks have fallen?

But the Fed didn’t give up, and by the late summer of 1929 short term rates were at 6%.  Recall that this was a very high real rate, as there was deflation during the 1927-29 business cycle expansion, despite the fact that the economy was booming.  So the trend rate of inflation in 1929 was almost certainly negative. Finally money got so tight that the economy tipped into depression.  And it was (expectations of) the depression that caused the stock market crash, not the high interest rates.  Indeed stocks hit the all time high in early September 1929, when interest rates were also near an all time high in real terms.  Only when the Fed caused the economy to tank did the stock “bubble” finally burst.  (BTW, studies have shown that stocks were not overpriced in 1929.)

The problem here is that monetary policy is a very blunt instrument.  Stein is wrong in assuming that the Fed has specific monetary policy tools that can surgically attack bubbles.  But they do have regulatory policies that can and should be used to prevent excessive risk taking in the banking system.

I know what you are thinking; “Sumner, we get that you don’t agree with Stein, but no reason to accuse him of child abuse.”

I have two responses:

1.  I don’t consider spanking to be child abuse.

2.  Governor Strong had this to say shortly before he died:

Must we accept parenthood for every economic development in the country?  That is a hard thing for us to do.  We would have a large family of children.  Every time one of them misbehaved, we might have to spank them all.

Excessive NGDP growth requires a good spanking—the rest of the misbehaving children need to be addressed with regulatory measures.


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23 Responses to “Jeremy Stein wants to spank all the little children”

  1. Gravatar of Adam Adam
    8. February 2013 at 08:36

    I’ve not read the whole papers, but isn’t the a major point monetary accommodation to create “underlying economic environment [that] creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield?”

  2. Gravatar of Saturos Saturos
    8. February 2013 at 08:45

    Aren’t these guys supposed to be Wicksellians? Don’t they know that they can’t affect the interest rate permanently without causing an inflationary/deflationary spiral? How could transient liquidity effects on rates ever be a serious regulatory tool anyhow?

  3. Gravatar of Saturos Saturos
    8. February 2013 at 08:50

    Btw, is the spanking philosophy something you arrived at on your own, or was it acquired from your wife’s culture? (Yes, I’m going for the worm can.) Surely one has to be on the receiving end of such treatment before one can give oneself the authority to deal it out. That’s also why I have no views whatsoever on abortion (which is de facto acceptance, I guess – when in doubt, don’t convict anyone.)

  4. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    8. February 2013 at 09:17

    ‘Only when the Fed caused the economy to tank did the stock “bubble” finally burst. (BTW, studies have shown that stocks were not overpriced in 1929.)’

    Yet, in the popular press that’s ignored. You can hardly read a newspaper without reading some lament about how we should ‘re-enact Glass-Steagall because that’s what kept us Depression free for seventy years’.

    Btw, Saturos, I don’t think ‘Spare the rod and spoil the child.’ is Chinese.

  5. Gravatar of marcus nunes marcus nunes
    8. February 2013 at 09:31

    A modern example comes from Britain. In late 1999, worries about a boom in shelter (home, apartments)prices in the SOUTH EAST region of the country, was one of the reasons for the BoE to raise rates.
    “Spank the whole country because the French are running away from high MTRs and building what came to be the “French Silicon Valley”, only it´s located in the London-Dover corridor.”

  6. Gravatar of ssumner ssumner
    8. February 2013 at 10:33

    Adam, I hope that’s not why people favor monetary stimulus.

    Saturos, I’ve been spanked—but not recently :)

    I don’t spank others.

    My personal situation has no bearing on whether I regard it as child abuse, or even whether I think it’s a good idea (a completely separate issue.)

    Otherwise I agree.

    Marcus, Just to play the devil’s advocate, didn’t Britain avoid recession in the 2001 cycle? If so, wasn’t their policy effective?

  7. Gravatar of marcus nunes marcus nunes
    8. February 2013 at 11:07

    @Scott
    The Brits had NGDP evolving closer to trend than any other country in 1993-07. They sure did avoid the 2001 recession. I just recalled that one of the reasons (excuse?) to notch the rate up by 25 bp in 1999 was funny. Glad it didn´t do any harm.

  8. Gravatar of Paul Zrimsek Paul Zrimsek
    8. February 2013 at 11:44

    If financial markets took until the fall of 1929 to figure out that the monetary policies put in place in the fall of 1928 were going to tank the economy, that doesn’t seem to bode too well for your NGDP futures market.

  9. Gravatar of Adam Adam
    8. February 2013 at 12:10

    Perhaps I’m missing an important distinction, but I don’t see much difference between “take on more credit risk in a reach for yield” and being more willing to lend due to rosier expectations about NGDP growth, especially in an environment with less than desirable levels of lending.

    Or to put it a bit more traditionally (I think), isn’t the point of lower interest rates and/or increasing inflation expectations to make credit risk relatively more attractive? I won’t lend to Prof. Sumner today because I don’t think the return is worth the risk, but monetary policy might change that judgment if it can convince me that economy (and thus Prof. Sumner) will perform better than my current expectations. Isn’t that change in my attitude “taking on more credit risk?”

  10. Gravatar of dtoh dtoh
    8. February 2013 at 14:16

    Scott,
    It’s simple and I’ve said it many, many times before. Give the Fed the power to dynamically set maximum and minimum asset/equity ratios by asset class for financial institutions.

  11. Gravatar of Steve Steve
    8. February 2013 at 16:02

    “only the very best monetary economists in the world should be allowed to serve on the FOMC”

    But Greenspan was a consultant, and Bernanke (used to be) one of the best monetary economists in the world, right?

  12. Gravatar of Neal Neal
    8. February 2013 at 16:47

    Wall Street = Castle Anthrax?

  13. Gravatar of Geoff Geoff
    8. February 2013 at 18:22

    dtoh:

    “It’s simple and I’ve said it many, many times before. Give the Fed the power to dynamically set maximum and minimum asset/equity ratios by asset class for financial institutions.”

    Boom I just invented another asset class not under regulation.

    Steve:

    “But Greenspan was a consultant, and Bernanke (used to be) one of the best monetary economists in the world, right?”

    I’ve been inquiring Dr. Sumner to explain what he means by only those who “understand” monetary economics should control the Fed, and why his list of economists deserves to be on the FOMC, while most of the current crop do not.

    So far, I have only been able to glean “understand = support NGDP targeting” out of things, and only by suspicion more than anything else.

    Of course, since control of the Fed is not up to the wills of sovereign individual end seekers (consumers) and their property, it really boils down to “my way or else the government’s guns”, which is fine by me, I just wished it was more clearly expressed, and not dressed up in some fake rational/intellectual standard that can only superficially appear as a list of a minimum intellectual criteria.

    This is I think why I was treated with a tinge of hostility and intimidation by being basically told THOSE ARE 20 NOBEL PRIZE WINNERS SO SHUT UP.

  14. Gravatar of ssumner ssumner
    8. February 2013 at 19:07

    Paul, The policy of 1928-29 was a fine policy, it just didn’t kill the stock boom. When the policy did do that, the markets reacted quickly.

    Adam, No, the central bank should never encourage lending, or the buying of any specific product like houses or cars. They should focus on NGDP, nothing else.

    Steve, Yes, Bernanke is much more qualified than Greenspan.

  15. Gravatar of dtoh dtoh
    8. February 2013 at 19:14

    Geoff,

    “Boom I just invented another asset class not under regulation.”

    Boom, it falls into the unclassified asset class which is subject to a minimum 50% equity to asset ratio.

  16. Gravatar of Paul Zrimsek Paul Zrimsek
    9. February 2013 at 14:03

    OK, but now we have a story in which the markets granted the bad deflationary policy of 1929 a credibility which they’d earlier denied to the good deflationary policy of 1928. What made them change their minds? (If we’re going to hold on to anything resembling the EMH, the markets must have gotten some piece of momentous news in the fall of 1929.)

  17. Gravatar of Negation of Ideology Negation of Ideology
    9. February 2013 at 15:02

    “During the 1920s NY Fed President Benjamin Strong was under a lot of pressure to “do something” about the stock market boom. He resisted, arguing the Fed should focus on stabilizing prices and output. (Hmmm, what is the sum of the growth rate of prices and the growth rate in output?) He died in August 1928, and the new leaders of the Fed finally had their chance. They raised interest rates in late 1928, and then in early 1929, and then in mid-1929.”

    I recall Milton Friedman (and I believe Irving Fisher) said that if Benjamin Strong hadn’t died the Great Depression may not have happened, it might have been a “garden variety recession.” I also remember myself worrying that Alan Greenspan wouldn’t be at the Fed forever, and if we’d see problems after he leaves. (He’s still alive, of course, but not Fed chairman.)

    The beauty of NGDPLT, of course, is it doesn’t depend on Benjamin Strong or Alan Greenspan staying chairman forever.

  18. Gravatar of ssumner ssumner
    10. February 2013 at 13:20

    Paul, I’ve written a lot on that very topic. (Buy my book later this year!) It turns out that the policymaking process is extremely complex, especially when constrained by the gold stnadard. So it’s not surprising that there was great uncertainty about the future course of policy. Without knowing the future course of policy, it’s hard for markets to know how to react to the current stance of policy.

    Negation, Hawtrey also made that claim about Strong. I think the claim for Greenspan is far weaker, however—no indication he would have done differently.

  19. Gravatar of Geoff Geoff
    11. February 2013 at 04:07

    dtoh:

    “Boom, it falls into the unclassified asset class which is subject to a minimum 50% equity to asset ratio.”

    Boom it is no longer an asset on the books via accounting rule caveat 132.989-A

  20. Gravatar of TheMoneyIllusion » What monetary policy can and cannot do TheMoneyIllusion » What monetary policy can and cannot do
    11. February 2013 at 10:51

    [...] current policy so much as how the Fed should behave in general.) Scott Sumner, a blogger, was unimpressed by Mr Stein’s analysis, arguing that it was uninformed by history. However, the [...]

  21. Gravatar of How Overpriced Were Stocks in 1929? Crossing Wall Street How Overpriced Were Stocks in 1929? Crossing Wall Street
    12. February 2013 at 07:46

    [...] Sumner recently wrote, “studies have shown that stocks were not overpriced in 1929.” This observation [...]

  22. Gravatar of Mark A. Sadowski Mark A. Sadowski
    12. February 2013 at 16:13

    Scott wrote:
    “…studies have shown that stocks were not overpriced in 1929.”

    The 1929 Stock Market: Irving Fisher Was Right
    Ellen R. McGrattan and Edward C.Prescott
    November 2004

    Abstract:
    “Many stock market analysts think that in 1929, at the time of the crash, stocks were overvalued. Irving Fisher argued just before the crash that fundamentals were strong and the stock market was undervalued. In this paper, we use growth theory to estimate the fundamental value of corporate equity and compare it to actual stock valuations. Our estimate is based on values of productive corporate capital, both tangible and intangible, and tax rates on corporate income and distributions. The evidence strongly suggests that Fisher was right. Even at the 1929 peak, stocks were undervalued relative to the prediction of theory.”

    http://www.cfr.org/content/thinktank/Depression/Fisher_McGrattenPrescott.pdf

  23. Gravatar of Dangerous Monetary Policy | Fifth Estate Dangerous Monetary Policy | Fifth Estate
    21. February 2013 at 17:57

    [...] as expected, insisted that monetary policy should be directed solely at keeping nominal GDP on a target growth [...]

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