In the NYT this morning, David Leonhardt writes that the Federal Reserve should do more to push against inflating investment bubbles:
The Fed could have tightened financial rules, like the amount of cash that must be put up for a given investment. It also could have used the bully pulpit. Imagine what might have happened in 2005 if Mr. Greenspan or Mr. Bernanke had explained the obvious risks with adjustable-rate mortgages and just urged home buyers to be more conservative.
The argument that the Fed should get into the bubble-pricking business is a popular one these days. Morgan Stanley’s Steve Roach just made it in the pages of Fortune, PIMCO’s Paul McCulley has been making it for a while, etc.
And I guess, in some Platonic (or Bagehotic) ideal world of central banking, that’s exactly what the Fed should do. But the real world is a bit more complicated. Martin Wolf has a column in today’s FT explaining why this particular housing bubble would have been hard for the Fed to prevent (because of the global “savings glut,” he says), but I’m thinking more of two timeless factors.
One is Alan Greenspan’s claim that even Fed chairmen can’t necessarily recognize bubbles until after they’ve popped. He’s only partly right about that: I think it’s fair to say that the preponderance of smart people who pay attention to these things knew the stock market had gone mad in 1999 and the real estate market in 2005. The complication is that some of those same people thought the stock market was crazy in 1996 and the real estate market in 1999. It’s really hard to get the timing right, and if as Fed chairman you get the timing wrong you can end up in a whole lot of political trouble.
Which, in the end, is the biggest complication. It’s just not politically realistic to think that Fed chairmen can get away with leaning against the wind a whole lot more than they do now.
University of Delaware economist Burton Abrams documents in a Fall 2006 Journal of Economic Perspectives article how much pressure Richard Nixon put on then Fed chairman Arthur Burns to go easy on monetary policy in the runup to the 1972 election. The subsequent inflationary spiral, and the successes of Paul Volcker at ending it and Greenspan at keeping it down won for the Fed a greater measure of independence.
But it’s a very conditional sort of independence, and I think a Fed chairman who continually railed against prevailing political and economic trends would soon find himself losing clout and maneuvering room. Harry Reid famously called Greenspan “one of the biggest political hacks we have here in Washington,” and he wasn’t entirely wrong. But somebody without good political instincts and a willingness to follow them could never have survived in that job for 19 years. And by staying on the job for so long Greenspan was able to gain for himself a measure of independence in setting monetary policy that Arthur Burns could only have dreamed of. Which was a good thing.