The Fed Chairman, Ben Bernanke, has emerged from the shadows in his most recent speech, after the grueling re-confirmation hearing. Closely following a recent speech by Federal Reserve Governor Kevin Warsh on the shadow markets, Bernanke has attempted to place the crisis that evolved since the Summer of 2007 in the context of the shadow markets. He stated, without mincing words, that the crisis was caused by the shadow markets.
Bernanke is correct in his judgment that the overleveraged and unregulated portion of the financial markets had caused the financial crisis. He did not, however, say that the monetary policy of the Federal Reserve, by introducing moral hazard to standby in the event of market failures, had contributed to such market behavior. Together, these two causes had brought about the disaster.
It is clear that the Fed, even though it cannot subject market behaviors to government edicts, can no longer continue that policy status quo, with or without financial regulatory reform. The Fed’s consistent support of Alan Greenspan’s stated policy of monetary expansion upon or anticipated financial market failure is up in the air. The least it can do, therefore, is to change its behavior by withdrawing the promise of monetary accommodation should markets fail, reversing Alan Greenspan.
The crisis was caused by the shadow markets not because they had overleveraged themselves over 1 per cent of the housing market, bringing a 15 trillion dollar economy down (or a notionally valued economy worth $150 trillion at its peak). Most Americans are still paying on their mortgages. Had this not been the case, the government sponsored enterprises (GSEs) would be a federal liability.
The crisis was caused by the expectations of the markets that all of housing and commercial real estate, whether those financial assets were maintaining a steady stream of cash flow or not, was overvalued and that it had to correct itself at some point. The markets failed to delineate the more risky assets from the moderate and least risky assets even though they had done so while packaging them into tranches. They left in droves from the real estate market into other markets that promised relatively higher yields such as the commodities markets, raising the prices of grain and oil around the world. The diminishing yields in housing at the peak of the bubble had triggered the exit.
The Fed Chairman may have had a political reason to suggest that the shadow markets were responsible for the housing crisis, in broad brush terms. He may have wanted to blame them to bring them under regulation. True. They must be brought under regulation, but not because the subprime crisis caused the economic meltdown, for it could have been avoided altogether by changing their own behaviors and by the Fed, its behavior. They must be brought under regulation to enhance the structural integrity of the financial innovations. And the best regulation is open markets or all financial innovations trading in open exchanges after standardizing their contracts by type with the government monitoring for market fraud.
The Fed, should it change its behavior, must replace its current policy stance with something else to guide market expectations in a more disciplined manner. The Fed’s largely ad hoc role in the crises over the last two decades has been quite correctly blamed on the leeway it says it must need to fulfill its mandate. This leeway is known more technically as discretion. Discretion, in fact, confuses the markets more than it enlightens them because the Fed says it cannot tell them what it does not know yet.
The debate over Fed’s transparency is obfuscated by the debate over whether the Fed can communicate the path of the federal funds rate accurately. It cannot as the Fed’s outgoing Vice Chairman Don Kohn recently also pointed out in a speech. However, what the Fed can do is to let all of its stakeholders in the economy know with certainty how much inflation it is willing to tolerate. Monetary policy transparency is all about the inflation tolerance of a central bank, never the path of its interest rate.
A central bank can, at all times, be clear about its inflation objectives leaving itself the elbow room to vary money supply (or interest rates) to achieve its inflation objectives over its forecast horizon of three years, with the understanding that in any time horizon inflation never exceeds its upper limit of tolerance, keeping the markets abreast of current inflation and future inflation possibilities at all times. This is also known as time consistency in monetary policy.
The effect of fiscal indiscipline on inflation is well known. As government borrowings rise well beyond its and the nation’s earning capacity, lenders seek ever higher interest rates to lend money. Because the markets borrow at a lower rate in the short term and lend at a higher rate in the long term, the borrowing costs for investment rise eventually cascading into prices causing inflation. Higher product prices put a higher pressure on wages, further reinforcing the cycle of inflation. Therefore, Ben Bernanke is correct that the government of the United States must rein in its government spending. Fiscal discipline is time consistency in fiscal policy.
The big government expenditures on the horizon, which are mandatory, are social security and Medicare, which is also quite accurately cites as the primary causes of concern to enjoin the government to do something about them. However, the central problem of these expenditures is not as much the expenditures per se, but the dependence of every generation on succeeding generations to meet those expenditures. And it is this fiscal link between overlapping generations that must be broken by making each generation responsible for its own retirement and health security in old age. This requires social security reform to implement the delinking and improvisation of the current health care law to do the same.
The Fed Chairman, in a timely manner, touches upon three seminal issues in economic policy: time consistency in monetary policy, in fiscal policy and the integrity of the country’s financial markets. We can only hope that the government follows through on this opening of the rhetorical window.