Wednesday, August 22, 2007

The Federal Reserve is flying blind

There's no question that the Federal Reserve's response to the current market turmoil has been belated, clumsy and not terrible effective. Many attribute it to rookie mistakes by Chairman Bernanke. But I think it goes beyond that. To understand the Fed's actions, its worth exploring the way some of that institutions top officers look at these issues. From what I've seen so far (read on), no wonder we're f***d.

Let's begin with Frederic Mishkin, a noted economist and member of the Federal Reserve's Board of Governors and its Open Market Committee. Last January he gave a speech where he laid out his thinking of asset prices and monetary policy.

First, Mishkin states that he doesn't believe central banks should actively seek to puncture bubbles of any kind, but other central bankers hold the opposite position. Having said that:

There is no question that asset price bubbles have potential negative effects on the economy. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy. For example, if home prices rise above what the fundamentals would justify, too many houses will be built. Moreover, at some point, bubbles burst and asset prices then return to their fundamental values. When this happens, the sharp downward correction of asset prices can lead to a sharp contraction in the economy, both directly, through effects on investment, and indirectly, through the effects of reduced household wealth on consumer spending.

This is not complacency. He knows the danger. But what should central banks do when they see frothy real estate markets?
A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets. Indeed, the view that government officials know better than the markets has been proved wrong over and over again. If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further.

This brings to mind the joke about the economist who refuses to pick up a dollar bill on the sidewalk (see here). A rather lame argument, if I may say so myself. But let's move on to a key section of his speech (bold type is my emphasis):
A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed. Asset price crashes can sometimes lead to severe episodes of financial instability, with the most recent notable example among industrial countries being that of Japan. In principal, in the event of such a crash, monetary policy might become less effective in restoring the economy's health. Yet there are several reasons to believe that this concern about burst bubbles may be overstated.

Go oooon!
To begin with, the bursting of asset price bubbles often does not lead to financial instability. In research that I conducted with Eugene White on fifteen stock market crashes in the twentieth century, we found that most of the crashes were not associated with any evidence of distress in financial institutions or the widening of credit spreads that would indicate heightened concerns about default.5 The bursting of the recent stock market bubble in the United States provides one example. The stock market drop in 2000-01 did not substantially damage the balance sheets of financial institutions, which were quite healthy before the crash, nor did it lead to wider credit spreads. At least partly as a result, the recession that followed the stock market drop was very mild despite some severely negative shocks to the U.S. economy, including the September 11, 2001, terrorist attacks and the corporate accounting scandals in Enron and other U.S. companies; the scandals raised doubts about the quality of information in financial markets and ultimately did indeed widen credit spreads.

Most, Mr. Mishkin, is not good enough. And this argument is misleading. First, we're talking about real estate, not stocks. Second, credit spreads did jump dramatically in 2001-2002, as a lot of the excessive tech and telecom investments --which were made due to the wildly optimistic assumptions that were also reflected in stock prices---went bust. Things did not get very ugly because rates were quickly cut.

There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value ratio for residential mortgages is usually substantially below 1, both because the initial loan is less than the value of the house and because, in conventional mortgages, loan-to-value ratios decline over the life of the loan. Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble.

Yes, residential bubbles are not common. That's precisely why the Fed should've been much more worried! But what really shocks is that time has stood still for Mr. Mishkin. He still sees a world of bank-originated plain vanilla mortgages taken out by solid, creditworthy citizens which are then are sold to prudent investors through bonds packaged by Freddie Mac and Fannie Mae. It's as if the whole subprime/Alt-A thingy never happend.

Clearly, even Mr. Mishkin grants that bubbles can exist and burst. So what happens then?

Instead of trying to preemptively deal with the bubble--which I have argued is almost impossible to do--a central bank can minimize financial instability by being ready to react quickly to an asset price collapse if it occurs. One way a central bank can prepare itself to react quickly is to explore different scenarios to assess how it should respond to an asset price collapse. This is something that we do at the Federal Reserve.

Indeed, examinations of different scenarios can be thought of as stress tests similar to the ones that commercial financial institutions and banking supervisors conduct all the time. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can minimize the damage from a collapse of an asset price bubble without having to judge that a bubble is in progress or predict that it will burst in the near future

I have a word for this: GIGO. Yes, the universal law of garbage in, garbage out has proven itself once again. Is it any wonder that the Fed's response has been slow and not very effective when it has ignored the changes in the mortgage market? Evidently, their "stress tests" were based on unrealistic/deficient/naive assumptions.

This is very, very worrisome. The Federal Reserve is flying blind through a raging storm. Better buckle-up.