Economics One

In her  article “Alan Greenspan: What Went Wrong” in the Wall Street Journal Alexandra Wolfe considers whether monetary policy played a role in exacerbating the housing boom going into the financial crisis by holding interest rates “too low for too long.” I’ve argued that it did  (along with regulatory lapses) and wrote about it in a 2007 Jackson Hole paper.

Alan Greenspan disagrees with that paper, as Alexandra Wolfe reports, but she also reports that “Prof. Taylor stands by the paper in which he presented the idea. ‘The paper provided empirical evidence…that unusually low interest rates set by the Fed in 2003-2005 compared with policy decisions in the prior two decades exacerbated the housing boom,’ he wrote in an email. Other economists have corroborated the findings, he added, and ‘the results are quite robust.'”

Understandably, there’s not enough space in such an article to list the corroborations that I mentioned, so here is a summary:

In 2008 Jarocinski and Smets of the European Central Bank found evidence in the U.S. that “monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002-04 has contributed to the boom in the housing market in 2004 and 2005.”

In 2010, George Kahn of the Federal Reserve Bank of Kansas City found that “When the Taylor rule deviations are excluded from the forecasting equation, the bubble in housing prices looks more like a bump.”

There is also related international evidence. In 2010 Rudiger Ahrend of the OECD found “‘below Taylor’ episodes have generally been associated with the build-up of financial imbalances in housing markets.”

And there’s historical evidence: Just last year Bordo and Landon Lane reviewed the existing research and showed that over  many countries and across many time periods asset price acceleration regularly follows such  excessive monetary accommodation.

And in his comprehensive history of the Fed, monetary historian Allan Meltzer said this about the decision to hold interest rates so low during the 2003-05  period: “That was a mistake” (p 1248).

Alan Greenspan is a  good friend and he led the Fed during one of its more successful periods. Allan Meltzer wrote that the period from 1985 to 2003 was the longest periods of good monetary policy in the Fed’s history.  Nonetheless,  there is evidence that monetary policy in 2003-2005 was at least was a factor  in exacerbating the housing boom.

Twenty years ago, a new legal requirement for central bank independence was introduced in Mexico. Here is the English translation:

The State shall have a central bank, which shall be autonomous in exercising its function and management. Its main goal will be to foster the stability of the national currency’s purchasing power, therefore strengthening the State’s role in guiding the country’s development. No authority shall order the central bank to grant financing.

The results were amazing. The inflation rate fell from a 43% average from 1970-94 to 4 percent during the last decade.

But it was not only the law that made this accomplishment possible. It was the steady implementation of the law with a rule-like monetary policy (a type of inflation targeting) by three governors of the Banco de Mexico (Miguel Mancera, Guillermo Ortiz, and Agustin Carstens) and their staffs during the past twenty years.  It was also due to their maintaining a degree of de facto independence to match the de jure independence.

This was not easy.  The history of central banking shows that de jure independence does not always lead to de facto independence or to rule-like monetary policy.  In fact, within a given law (de jure independence), there can be (1) variations in the degree of de facto independence, (2) variations in rules-based vs. discretionary policy, and, as a result, in my view, (3) variations in macroeconomic performance.

In the U.S.A for example, there were virtually no changes in de jure independence in the past half century. Although there were several changes in the Federal Reserve Act, well-known indices of de jure central bank independence show little change. In contrast, there were large changes in de facto independence.  According to historical research by Allan Meltzer, Marvin Goodfriend, and Otmar Issing, the 1970s and recent years show deviations from de facto independence compared with the 1980s, 1990s and until recently.  These periods are also characterized by discretionary rather than rule-like policy.  And of course macroeconomic performance was much worse during those periods.

Some relevant facts and figures are in these slides which I presented yesterday at the Banco de Mexico Conference celebrating 2o years of central bank independence in Mexico at which many central bankers and the President of Mexico spoke. Congratulations Miguel, Guillermo and Agustin.

Congratulations to Janet Yellen. The new chair’s most important challenge, in my view, is to lead the Fed toward a more predictable, less interventionist, more rules-based monetary policy of the kind that worked well when tried, as in the 1980s, 1990s and until recently.  The sooner the Fed gets back to such a policy, the sooner the U.S. economy will begin performing well as it did in those earlier decades, which have been called the Great Moderation or the Long Boom.

In this respect, it is promising that Janet Yellen has argued that “in normal times, when the economy is buffeted by typical shocks—not the extraordinary shock resulting from the financial crisis—simple rules can come pretty close to approximating optimal policies.” But, as of a year and a half ago, she also added that “times are by no means normal now, and the simple rules that perform well under ordinary circumstances just won’t perform well…”

So, although Janet Yellen has been rationalizing the recent departure from rules-based policy, she wants to get back to rules-based policy.  In fact, she has been the most vocal advocate of such a return of any Board member including the current Chair. The sorely needed “great unwinding” will of course be difficult.  The question is when and whether she will be able to pull it off. I wish her the very best.