Optimal crises

Jul 2nd 2014, 20:32 by G.I. | WASHINGTON, D.C.

Janet Yellen, the Federal Reserve chair, has long said there might be times when monetary policy could be used to counteract financial instability. But in a speech before the International Monetary Fund today, she erected such a high bar to its use that is seems unlikely ever to happen: the “potential cost … is likely to be too great … at least most of the time.”
The unstated logical conclusion is that there is some optimal exposure to crisis. The Fed obviously can’t say this, but this has long been implicit in how it operates. In fact, it was explicit in Alan Greenspan’s doctrine of mopping after bubbles rather than popping them. Mr Greenspan advanced another argument after the crisis: that monetary policy could not have popped the housing bubble because a global savings glut had clawed control of long-term rates away from the Fed. This was wrong; there is some level of short-term rates that the Fed could have engineered that would pop the bubble. The problem is that the level would have been so high as to tank the economy. Mr Bernanke’s (and now Ms Yellen’s) response to emerging markets who complain that easy American monetary policy is destabilizing their economies is a variation of this logic: bad as the spillovers of easy policy are, emerging markets would suffer more if the Fed were to prematurely raise rates and weaken U.S. demand for the world’s goods.
In theory, the Fed doesn’t have to accept the ugly tradeoff between financial stability and growth because it can use macroprudential regulation to make the financial system resilient against the threat of burst bubbles and other shocks. Ms Yellen made it clear this is, and will remain, the first line of defense against financial instability. In practice, though, the tradeoff will still exist. Monetary policy works by spurring borrowing, and macroprudential policy cannot become so effective that it brings borrowing to a halt. It may serve to maintain stability long enough for leverage to grow even further. Before the crisis, Spain was the world’s model macroprudential practitioner. It used counter-cyclical provisioning to force banks to build up reserves against losses in good times that would be available to cushion defaults in bad times. Yet Spain also experienced a surge in househhold debt when accession to the euro caused real interest rates to plummet. Spain’s macroprudential tools simply weren’t up to the task of countering the rise in leverage, or of protecting the financial system when that massive credit bubble burst.
Ms Yellen acknowledges that emerging threats may go unnoticed or unaddressed by macroprudential policies. At such times, “adjustments in monetary policy may … be needed.” But it’s hard to imagine a circumstance in which the possibility of a future crisis would carry more weight than the certainty of an immediate loss in economic output – even less so when inflation is too low, unemployment uncomfortably high and equilibrium interest rates depressed. A paper by Dave Reifschneider, William Wascher, and David Wilcox, top economists at the Fed, simulated two responses to a financial crisis. In one, rates fall to zero, and another crisis, 60% as bad as the first, erupts ten years later. In the other, rates are not allowed to fall below 1.5%, and the second crisis is avoided. As we noted in a recentarticle, they concluded that even with the second crisis, the cumulative loss of income and employment is far smaller in the first scenario.
The Fed sincerely believes that financial stability risks are both contained, and containable. But implicit in Ms Yellen’s logic is that there is a price for preventing all future crises – and sometimes, that price may be too high.

The original post is linked here.

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