Central Banks Reconsider Doctrine of Preemption:

Commentary by Caroline Baum

Oct. 15 (Bloomberg) — It is an article of faith that central banks can’t identify an asset bubble ex ante; that they don’t have better knowledge of the appropriate level of asset prices than financial markets; that they can best serve the public by addressing the aftereffects of the bubble once it bursts.

With central banks around the world pulling out all the stops to keep money flowing, banking systems functioning and economies growing (or not sinking so much), perhaps a re- evaluation of the doctrine of preemption is in order. If central banks are willing to risk trillions of taxpayer dollars in their role as lender of last — make that only — resort, then an ounce of prevention may just be a better policy prescription.

The doctrine of preemption poses obvious problems, which is why most policy makers take a hands-off approach.

First, it presumes they can identify a bubble. Second, it implies a consensus on the role asset prices play in the determination of inflation and employment. Third, it assumes monetary policy is the appropriate instrument for bubble management. In some cases, the irrational exuberance over an asset, be it tulips or tech stocks, may be so great that the interest rate required to prick the bubble would inflict undue hardship on the economy.

European central bankers have traditionally been more willing to consider asset prices as part of their monetary policy toolkit.

Prevention vs. Clean-Up

“Prevention (of asset bubbles) is the best way to minimize costs for society from a longer-term perspective,” said Otmar Issing, the former chief economist for the Deutsche Bundesbank and European Central Bank, in a Feb. 19, 2004, Wall Street Journal op-ed. “Most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit.”

The central bank can’t control how money is allocated — whether it flows into goods and services or into assets — “but it can try to control its supply,” he said.

Broad money growth accelerated through the latter half of the 1990s. Sure, the Nasdaq went nuts, rising 86 percent in 1999, but inflation stayed tame. Why point a finger at the Federal Reserve?

Tame inflation “isn’t the only reason to keep rates low,” said Marvin Goodfriend, professor of economics at Carnegie Mellon University’s Tepper School of Business in Pittsburgh. “Higher trend productivity growth needs higher real interest rates to keep inflation stable.”

Role of Credit

Goodfriend, who was director of research at the Richmond Fed, and Richmond Fed President Al Broaddus argued internally at that time for higher real rates. “It would have acted against the worst excesses of the tech bubble,” Goodfriend said.

While a 1 percent fed funds rate was necessary in 2003-2004 to fend off deflationary threats, “we didn’t move rates up fast enough” after that, he said.

The current crisis, which has witnessed the demise of venerable financial institutions and the intrusion of government into the private sector in ways not seen since the 1930s, is prompting many economists to reconsider the doctrine of preemption.

“I was always skeptical of the ability of the central bank to target asset prices,” Broadus said in a phone interview yesterday. “I haven’t given up that skepticism, but after an event of this magnitude, the Fed has an obligation to look at this.”

Broaddus said the “credit phenomenon” — specifically too much of it — goes to the heart of an asset bubble and provides a starting point for understanding the process.

Role Review

The Fed staff will have plenty of time to study the relationship between credit creation and asset bubbles as the central bank ministers to the financial system and addresses the fallout on the economy. What will the policy landscape look when the immediate crisis passes?

“Are we going to target asset prices?” said Neal Soss, chief economist at Credit Suisse. “You betcha.”

The Fed already targets asset prices, Soss said. “It targets a cash rate, which is the building block for all capital assets.”

Overdue for review, along with the doctrine of preemption, is the Fed’s role as lender of last resort and whether it should be housed under the same roof as monetary policy maker, Soss said.

Consistency Needed

“In 95 years, the Fed has never said what the lender-of- last resort policy is,” said Allan Meltzer, professor of political economy at Carnegie Mellon, whose “A History of the Fed, Volume 2” will be published next year. “It’s not consistent, and this time it made things worse.”

The Fed “bailed out Bear Stearns, not Lehman, and did something with AIG,” he said. “The Fed needs a consistent policy that tells us what it is willing to do.”

Meltzer’s criticism doesn’t end there.

“The Fed is a lousy regulator,” he said. “It did nothing about the savings and loan crisis. It papered over the Latam debt problem.” And this time around, “it could have warned about the problem publicly and tightened mortgage standards,” he said.

Hindsight is easy. The goal is to find a framework so that policy makers can practice preventative, not curative, medicine.

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